Brent Sheather is an Authorised Financial Adviser and a personal finance and investments writer.

At the risk of boring readers to death this week's story is another one about active versus passive fund management and financial advisors fees. Before anyone rolls their eyes and goes back to Facebook we will hopefully cover some new ground here and add to readers understanding of both topics.

What prompted this discussion was Vanguard in Australia sending the latest addition of the Standard and Poors Indices Versus Active Funds report (SPIVA). This publication "has been the de facto scorekeeper of the ongoing active versus passive debate since its first quarterly report in 2002".

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It calculates how well various types of manage funds perform relative to their benchmark index and their data base allows them to do this for shares and bonds in the USA, Canada, Europe, Japan, Australia and a number of emerging markets. Readers are presented with facts rather than the propaganda and mis-information typically associated with local discussion of this topic and can thus get a feel for the actual performance of actively managed funds in general versus the relevant benchmark index. The facts are that doing as well as the "average" is not only difficult but trying to outperform is fraught with danger.

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The September 30th report shows that active fund managers have found it particularly difficult to beat the index in the larger, more highly liquid stock markets like the US where 86% of active fund managers underperformed the S&P 500 index over a 1 year period and 89% underperformed over a 5 year period. In Europe 82% underperformed the benchmark over 5 years and, on the same basis, in Australia 78% did less well than an index fund.

However it seems that in some emerging markets active fund managers are able to genuinely add value - in India and Japan only 53% underperformed over a five year period. These results are consistent with portfolio theory which says that developed markets are more efficient than emerging markets and thus more difficult to beat.

Besides underperformance and high fees one of the other disadvantages of active fund management is the fact that returns are highly variable. In some years a fund manager will outperform and in others they will underperform. A financial advisor needs to be able to explain the reason for this variation to clients. The SPIVA report sorts active fund performance into quartiles. In Australia the top 25% of fund managers returned 6.7% in the last year versus 5.6% for the index but fund managers in the third quartile returned just 2.6%.

The dispersion was even greater for fund managers focusing on small companies with the first quartile returning 10.2% and the third quartile returning -2.6%. One thing that retired investors value is consistency because they often rely on the total return performance of their portfolios to fund living expenses.

Whilst these results clearly put the case for passive funds it is important to note that best practice, as evidenced by the portfolios of the average pension fund, is to have a mix of active and passive funds in portfolios. It is not a question of one or the other - a mix of both is best practice. One might wonder why given performance, fees, and variability that professional trustees advocate actively managed funds. The simple reason is that "we" collectively need to spend money on active management to make sure that markets are relatively efficient, that companies are priced properly and capital is allocated correctly. Passive funds don't do this so if everybody invested passively the basic function of the stockmarket would be greatly impaired.

It is a pity that Standard and Poors don't include NZ in the SPIVA report but we have had a rather crude attempt at doing this for the KiwiSaver growth oriented funds. The average asset allocation of these funds is around 10% in cash, 7% in NZ bonds, 7% in global bonds, 6% in property, 23% in Australasian shares and 47% in international shares. We make a few further assumptions and they are that the bond portfolio is split 50% NZ and 50% international and in respect of shares that the geographic split here is one-third Australasia and two-thirds international. The Sorted website summarizes the performance data for these funds over 1 year to 30 September 2015 and over 5 years to 31 March 2015 and we have calculated the performance of a benchmark on the same basis.

The numbers are as follows:

The Sorted website calculates the average growth oriented KiwiSaver fund return for 1 year is 6.78% with a high of 17.5% and the worst performer achieving -2.14%. Over 5 years the numbers are 7.44% pa, 12.1% and 4.25% pa respectively.

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So what do these numbers tell us?

Firstly, given long term performance is more important than short term, the fact that the average growth fund has slightly exceeded the performance of the index is good news for KiwiSavers. Most likely the reason for the outperformance over 5 years (and the underperformance over 1 year) probably comes down to the effect of hedging foreign currency as our index assumes that global bonds and equities are unhedged whereas in practice most KiwiSaver funds hedge all of their international bonds and 50% of their international share portfolio.

One last thought for today - a few weeks ago Tom Hartmann of the Commission for Financial Capability talked about fraud and how we need to be alert so that we don't become victims. One fraud he didn't talk about but one which is perpetrated daily by sophisticated fraudsters is in the investment area where people are promised the return of equities but receive, after fees, the return of bonds whilst incurring the risk of equities.

This fraud occurs because the annual fees implicit in many private banking investment plans total around 3% and the forward-looking risk premium of global shares over long dated bonds (think 30 year Treasury Bonds for example) is also around 3%. Sounds fraudulent to me - a bit like buying Red Band gumboots on Trade Me and then getting jandals in the post. Definitely not fair or putting client's interests first either is it?