Index Hugging
Sydney Morning Herald
Wednesday October 6, 2004
Why it is topical The imminent departure of News Corporation from the Australian stockmarket indexes shows just how ingrained the culture of index-hugging is among mainstream fund managers.
At last one of the big fund managers, MLC, has come out and said what many investors are thinking: that the practice of fund managers investing in companies they would not put their own money into is costing investors millions of dollars.What it is Paul Ireland, the head of Asset Consulting at MLC, points out that when it was announced that News would likely drop out of the Australian sharemarket indexes, its shares fell by 5.5 per cent."If you were an active manager and held News Corp on that day, and none of the fundamentals of the business have changed, why would you sell?" he asks.Of course, the only reason to sell is the likely exclusion of News from the index. Under the rules of the index compiler, Standard & Poor's, News cannot be simultaneously in the Australian S&P 50 and the US S&P 500 index.News Corporation is a notoriously volatile and unpredictable stock. To anchor to the index, News is a must-hold for mainstream managers of Australian share funds. Although News wants to relocate to Delaware and exit Australian stockmarket indexes, it will remain listed in both Australia and the US. There is nothing stopping Australian share fund managers from investing in News. However, Ireland says that what has occurred with News makes it clear that many managers were holding the stock because of the benchmark risk in not holding it. That is, the risk of producing returns below that of the Australian sharemarket, which could see disgruntled investors exit the fund and the loss of investment management fees. It's a factor that has everything to do with the risk to revenue of the fund manager and little to do with the investment risk for investors.How it fits in As Ireland says, what is the point in beating the benchmark when the fund is losing money for investors?For investors the real benchmark is not some artificial construct such as a market, but the rate they could earn, risk-free, on their cash.In the past MLC has itself been guilty of taking an asset consulting view of the world and requiring the fund managers that it contracts for its funds to invest closely to the index.The upshot of that approach for investors in MLC's equity funds - especially in Australian shares - is that the returns have been remarkably index-like, after fees are taken out. So it has been something of a conversion in approach for MLC. Over the past couple of years, MLC has instead encouraged its managers to invest with conviction, and to optimise returns and reduce risk.What should happen Ireland says that managers, who are supposed to be acting in the best interests of investors, have to review their conviction as to which stocks will provide the best returns for investors. He says if they do not think some will provide that return, then they should have the conviction to either not hold them or to sell them, rather than simply underweight them and watch them fall.
© 2004 Sydney Morning Herald