I hope to enlighten potential investors about the tricks used by fund managers to ‘window dress’ their performance. Some of these tricks can be backed out and where possible I have provided the math below.

Before we begin, let’s define and recap the role of Index Funds. Index Funds are mutual funds seeking to replicate the performance of a specific Index. They are available on almost every benchmark imaginable. The primary benefit of an Index Fund is its very small management fee. This means they can replicate the performance of a benchmark very closely on an after-fees basis. It is therefore easy to compare all active managers against their applicable Index Fund. An Active Manager is a term used to describe a fund manager attempting to beat the benchmark through stock selection.

Active Managers generally charge a management fee together with a performance fee. Regardless of the fees charged, the relevant metric is after fees performance. An active manager needs to earn back his/her fees prior to being paid for performance. Unfortunately, this is not always the case, so investors need to be alert to manipulations around fees and performance. We discuss the major manipulations below.

Selecting a benchmark index without including dividends

This is the most commonly used trick by fund managers. When you hold a stock, you are entitled to the dividends the stock pays. Accordingly, when you buy an Index Fund, you are entitled to the dividends on the stocks in the Index. Dividends can make a huge difference to your long term investment performance. The benchmark used should include the dividends of the Index. To illustrate, I include the return on the All Ordinaries Index with and without dividends. The return with dividends is called the ASX All Ordinaries Accumulation Index.

For example, the return on the ASX All Ordinaries Index was 8.5% for the year ending 30 June 2017. The All Ordinaries Accumulation Index, which includes dividends, returned 13.1% for the year ending 30 June 2017. If a fund manager wants to overstate his/her performance then they choose the lower hurdle i.e. 8.5% instead of 13.1%. You should ensure that your manager’s benchmark includes dividends.

Quoting performance before fees

To make a clear comparison, fund managers should be quoting their performance after fees. This is a no brainer, however, you may be surprised that some professional managers do not quote their returns after fees. You may adjust their performance by deducting the management fee from their published performance. This will ensure you are comparing apples with apples when you rate the performance of an Index Fund or another Active Manager.

Failure to deduct the management fee prior to calculating the performance fee

Assume a fund manager charges a 1.5% management fee and a 15% performance fee. Assume that he/she delivered a 10.5% return before fees and the benchmark delivered a 9% return. The fund manager could take a performance fee based on 1.5% outperformance. However, if you subtract the base management fee of 1.5% from the performance, he/she would have delivered a 9% return. The 9% return would not be entitled to a performance fee. It is critically important that the management fee is deducted prior to calculating the performance fee. Stay alert to this one! It can make a significant difference over the long term.

Performance fees paid quarterly

The payment of performance fees is another area of concern. The most common abuse is to calculate and pay performance fees quarterly. For example, assume a fund’s unit price begins at $1.00, reaches $1.10 by the end of the first quarter, before falling and finishing the year at $1.00. In this example, the unit holder’s investment began and ended the year at $1.00 i.e. their units have not increased in value. If the fund manager pays his/her performance fee quarterly, they would have paid themselves a fee at the end of the first quarter, when the unit price reached $1.10. However, if they calculated their performance fee annually, no performance fee would be payable. Beware of performance fees paid quarterly!

I hope this makes sense and allows you to more effectively choose the best fund for you.