(Pictured: David Gallagher)
By Barrie Dunstan
A recent study has raised questions about whether asset consultants and investors can rely on what fund managers tell them about how they manage equity portfolios.
A paper by three Centre for International Finance and Regulation (CIFR) researchers examined how well Australian equity managers complied with their stated portfolio characteristics – the number of stocks held, the portfolios’ tracking error and the turnover of stocks in the portfolio.
The study was done by Dr Zhe Chen, a CIFR research fellow, Professor David Gallagher, chief executive officer of the CIFR and Dr Camille Schmidt, a CIFR post doctoral researcher. It looked at the fund managers’ responses and checked daily transactions and monthly equity holdings.
It aimed to establish whether fund managers are running portfolios consistent with what they have disclosed – “in other words is the fund manager ‘true to label’.”
This, the study says, is an important source of information for asset consultants to help assess and recommend individual fund managers to institutional investors.
The study concludes that funds do generally comply with their self-declared limits in one measure – the maximum and minimum number of stocks in their portfolios. This is, essentially, the characteristic they have most control over and the one easiest for asset consultants and others to check.
But the funds showed lesser compliance with their self-declared numbers for turnover of stocks in their portfolio and the response on tracking error was the most systematically underestimated questionnaire response.
Declaring a lower maximum turnover rate in portfolios may lead clients to expect lower transaction costs than actually transpire. The study says it is unclear whether the mismatches in the characteristics of portfolios, versus the actual numbers, were due the fund managers’ intent or because of systematic underestimation by managers.
The findings applied equally during periods of market strength and weakness. The final database covers a sub-sample of 37 funds over 15 years from 1995 to 2010 inclusive – that is, both bull markets and the GFC-induced bear market.
The researchers couldn’t find strong evidence that compliance with the funds’ own declared characteristics improved in the post-2000 period, compared with the period before 2000, because of extreme market events such as the dot.com bubble collapse and the GFC.
For potential institutional clients of active fund managers, the paper suggests they should view managers’ self-declared limits on numbers of stocks, tracking error and turnover “as relative indicators of future investment characteristics rather than absolute limits.”
The researchers say that, given the variability in levels of compliance, funds should give more weight to actual investment characteristics if these are available.
The study suggests that, from a regulatory viewpoint, there could be potential value for investors if regulators explicitly provided more assurance about the accuracy of self-declarations and required questionnaires to be updated and reviewed annually to limit “staleness” and provide greater accuracy.
The study also raises the controversial question of funds “window dressing” portfolios – that is, making significant adjustments to portfolios near the end of a quarter by selling stocks with large losses and buying strongly performed stocks so that the portfolio appears favourable.
“Thus an extension in this area would be to determine whether managers make significant adjustments to their portfolios in order to comply with their self-stated ‘label’ in terms of characteristics such as number of stocks held, turnover and tracking error.”