Some investors choose to put their money in actively managed mutual funds and unit trusts for various reasons, including a lack of time to monitor the market, or paying someone who is skilled or an expert in this field to manage their money for them. That’s what the management fees are for. The return of these mutual funds and unit trusts often depend upon the investment skills of the fund manager to achieve market-beating returns. But, there might be cases when the management fees are not paid for any skill at all.

In an out-of-print investment classic, Margin of Safety, Seth Klarman wrote that ‘since clients frequently replace the worst-performing managers (and since money managers live in fear of this), most managers try to avoid standing apart from the crowd.’ This means that money managers prefer to stick with the herd rather than risk their career by making bold investment choices. This gives rise to closet indexers – money managers who try to mimic a market index without publicly acknowledging it. It’s a case of you can’t go wrong if you follow the crowd in the money-management business, and is unfair to investors – they could be paying lower fees by choosing an index fund or ETF instead.

For those wondering what gives Seth Klarman the right to make such a statement, consider this: he is the founder and president of Baupost Group, a hedge fund company with compounded returns of close to 20% per year since 1992. Remarkably, Klarman achieved such returns while often holding up to 50% of his portfolio in cash. This is a highly idiosyncratic move that few money managers dare to make.

Let’s take a look at one such example here in Singapore. Amundi Singapore Dividend Growth fund has achieved annualised net-of-fee returns of 4.8% (inclusive of dividends) for its investors from Dec 2009 to Dec 2012. DBS Group Holdings Ltd (SGX: D05), Singapore Telecommunications (SGX: Z74) and United Overseas Bank (SGX: U11), which are all components of the Straits Times Index (SGX: ^STI), make up the fund’s top three holdings as of 31 Dec 2012. In fact, the top 9 holdings in the fund’s portfolio, with a total weightage of 61.32%, are all components of the STI.

The fund’s movement and the STI might be tracking each other due to the close parallels of their composition. This would make any substantial outperformance of the market for the fund’s investors hard to achieve due to management fees, which eats into the returns. This fact is borne out by the SPDR Straits Times Index Exchange Traded Fund (SGX: ES3) having higher annualised returns of 8.55% (inclusive of dividends) in roughly the same time frame. Investors in the SPDR STI ETF are essentially investing in the STI as the ETF is meant to track the movement of the index.

The Foolish Bottom Line

Investors often do not bother checking the portfolio of their funds. But, in cases where even a rough glance shows a very strong resemblance between a market index and a fund’s portfolio, it might be in the investor’s best interest to switch out of the actively managed, high-management-fee fund to a passively managed, low-fee index fund or ETF. After all, what use is there for a management fee if lower cost and better-return alternatives are readily available?

Here at The Motley Fool, we believe that the best person to manage your own money is you. Take charge of your own finances by signing up here for your FREE subscription to Take Stock Singapore, The Motley Fool’s free investing newsletter. Written by David Kuo, Take Stock Singapore tells you exactly what’s happening in today’s markets, and shows how you can GROW your wealth in the years ahead. 

The Motley Fool’s purpose is to help the world invest, better.  The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Contributor Chong Ser Jing doesn’t own shares in any companies mentioned.

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