Active and passive fund management. A look at fund management performance against the Ghana stock exchange (GSE) composite index

Table of Contents

ABSTRACT

ACKNOWLEDGEMENTS

CHAPTER ONE
1.1 Introduction to the Ghanaian Economy, Fund Management, and Stock Exchange
1.1.1 The Concept of “Zero Sum Game” and Mutual Funds
1.2 Research Aim
1.3 Research Questions and Key Hypothesis
1.4 Dissertation Outline

CHAPTER TWO
2.1 Literature Review
2.1.1 Background to Index Funds
2.1.2 The Active/Passive Debate
2.1.3 Picking Fund Manager with Persistent Performance and the Predictability of Index Funds
2.1.4 Fund Managers Performance: Market Timing Skills or Luck?
2.1.5 The Continuous Popularity of Active Fund Management
2.1.6 Impact of Leadership, Market Segment and Market Cyclicality on Performance
2.1.7 Diversification and Index Funds
2.1.8 Active Share and Closet Index
2.1.9 The Ghana Stock Exchange
2.2 Summary of Literature Review

CHAPTER THREE
3.1 Research Methodology
3.2 Mutual Funds and Unit Trusts Industry in Ghana and Research Sample Size
3.2.1 Summary of Collective Investment Schemes Year on Year from 2006
3.3 Specific Data Used and Their Sources
3.4 Conduct of Analysis

CHAPTER FOUR
4.1 Data Analysis, Findings and Discussion of Findings
4.1.1 Performance of Funds with Data from 2006
4.1.2 Performance of funds with continuous 2 year data within 2006 and 2013
4.1.3 Fund Manager Efficiency
4.1.4 Summary of Returns Based on Absolute Averages
4.1.5 Performance Analysis Based on Jensen’s Alpha and Sharpe Index
4.1.6 Alpha and Sharpe Ratios before Cost
4.1.7 Alpha and Sharpe Ratio after Cost
4.1.8 Analysis of Funds with Continuous Data from 2006
4.1.9 Evidence of persistent performance
4.1.10 Portfolio Allocation and Performance
4.2 Research Hypothesis

CHAPTER FIVE
5.1 Summary of Findings and Conclusions
5.2 Summary of Key Findings and Contribution of Research Work
5.3 Further Studies and Study Limitations

REFERENCES

APPENDICES

ABSTRACT

The popularity of funds that replicate a market performance continue to surge and several literatures have documented the superiority of index funds outperforming their active fund management counterparts. Most of these studies have been based on data from developed, emerging and frontier economies including the USA, Britain, France, Japan, India and many other countries. This study joins the debate by analysing Ghana specific data to measure the performance of Ghanaian fund managers from 2006 to 2013. This is the first of such analysis in the Ghanaian context. Using aggregate average returns, Sharpe ratio and Jensen’s Alpha based on the Capital Asset Pricing Module (CAPM) as the key performance indices, the study finds that fund managers in Ghana by aggregation do not provide superior returns using the GSE composite index as the market return benchmark and that fund managers on average have underperformed the market during the period of study. The aggregate of their performance further worsen on a risk adjusted returns after factoring in fund managers cost. This notwithstanding, some fund managers on a risk adjusted average return basis outperformed the market return albeit funds with an asset allocation portfolio of not less than 60% equity. Although the Ghanaian economy exhibit signs of a frontier market, the research observed fund managers in Ghana do not exhibit market timing skills and stock selection abilities that would have made them outperform the market. Evidence of superior performance persistence is also not noticeable but consistency in underperformance is observed. The outcome of this work indicate superior outperformance by replicating the GSE composite index as compared to active fund management and adds to the existing works that suggest the failure of active fund management to outperform their benchmark over a continuous period.

ACKNOWLEDGEMENTS

My sincere gratitude goes to Dr. David Costa and Dr Roy Damary of RKC for exposing me to both the theoretical concepts and practical appreciation of money management. The exposure inspired me to undertake this research in fund management. I am also grateful to my research supervisor Dr. Barry Ip for accepting to supervise this work. His guidance, reviews, and his “keep going I will review the next chapter” has been invaluable and really kept me going. I am again highly appreciative to Dr Alistair Benson for coordinating to get me a supervisor on time as well as his continuous reminder of the deadline to submit the proposal for this dissertation.

Once more, I am truly grateful to all the fund managers that assisted and pointed me to the relevant sources for the data gathered for this work particularly, Nii-Ampa Sowa and Roselyn Dennis of Databank Asset Management Service Ltd.

CHAPTER ONE

1.1 Introduction to the Ghanaian Economy, Fund Management, and Stock Exchange

The Ghanaian economy has tremendously grown within the last three decades to become a lower middle income economy (The World Bank, 2014) and has had a direct impact on the growth of the financial system. According a PWC Ghana report, the financial sector grew in deposit mobilization by an average rate of 28% between 2008 and 2012 (2014 banking survey). This growth has however been characterized by fierce competition with one another to grow their respective deposits.

Unlike previously where the financial sector was predominately dominated by the commercial banks, the competition has widen to include finance houses, savings and loan companies, micro finance institutions, and collective schemes. Though the Ghanaian economy has opened up over the last three decades, financial investment opportunities were limited to traditional investment (Arboh, 2008) like treasury bills, bank deposits, debentures with finance houses. However, the trend is changing with investors looking for alternatives that provides higher returns on their investments. Mutual funds over the periods have been seen by many investors as that alternative (Arboh, 2008). The seemingly limited financial investment opportunities and the fact that retail investors lack the sophistication and skills to effectively put their funds into profitable investment led the emergence of Investment fund management in Ghana. Investment funds are sold in units and the fund manager serves as the centre that brings together individual funds as one aggregate investment giving the unit holder the advantage of economies of scale which would almost not be possible without the aggregation (Costa, 2011). Aside from the benefit of economies of scale including diversification, efficiency and benefit of professional management, investment funds are expected to relieve the investor from the burden of deciding how and where to invest and the professional fee paid is to enable the professional investor deal with such 'troubles'.

Investment fund managers have had over the years, the strategy of timing and actively buying value shares on the Ghana stock exchange (GSE) and government bills and bonds with the aim of beating the market or identified benchmark. Their strategy has been typically an active type in the sense that, they rely on speculation about short-term future market Movements (Hebner, 2013). The activities of fund managers can either be categorized as active managed funds as explained by Hebner or a passive managed type. ‘‘Passively managed funds try to replicate the performance of a market after adjusting for expenses incurred in tracking. A passive investor always holds every security from the market, with each represented in the same manner as in the market" (Sharpe, 1991). While actively managed funds have the objective to outperform a market or market sector after adjusting for net cost (Ferri and Benke, 2013). Philips et al (2014) also state: ''In fact, any strategy that operates with an objective of differentiation from a given benchmark can be considered active management and should therefore be evaluated based on the success of the differentiation.''

Elsewhere on the international market, index fund as an investment strategy has grown in popularity. It grew from 14% of assets under management in 2002 to about 22% in 2010 (Cremers, et al., 2015). There are several definitions of indexing and Vanguard (2014) defines indexing as an investment strategy that attempts to track a specific market index as closely as possible after accounting for all expenses incurred to implement the strategy. This has an underlying assumption of a “strategy that is weighted according to market capitalization” (Philips, et al., 2014). The objective of an index fund is to track the performance of a specific market index, for instance the GSE composite index. ''An indexed investment strategy—via a mutual fund or an exchange traded fund (ETF) for example — seeks to track the returns of a particular market or market segment after costs by assembling a portfolio that invests in the same group of securities, or a sampling of the securities, that compose the market.” (Philips, et al., 2014). An index is a group of securities designed to represent a broad market or a portion of the broad market (Philips and Kinniry, 2014).

Increasingly, the argument for the superiority of index as an investment strategy continue to rage on and after forty years since the first publication of a Random Walk Down Wall Street, Malkiel (2011) still believes that “Investors would be far better off buying and holding an index fund than attempting to buy and sell individual securities or actively managed mutual funds”. Warren Buffett, in a 1996 Shareholder Letter noted that “Most institutional and individual investors will find the best way to own common stock is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals”.

An active investor is one who is not passive. His or her portfolio will differ from that of the passive managers at some or all times. Sharpe (1991) notes that “because active managers usually act on perceptions of mispricing, and because such perceptions change relatively frequently, such managers tend to trade fairly frequently,-hence the term "active"”.

1.1.1 The Concept of “Zero Sum Game” and Mutual Funds

The concept of passive investment is born from the theoretical principle of zero-sum game (Philips, et al., 2014). Sharpe (1991) note that at any given time, returns from the market must be equal to the weighted aggregate returns of all holdings within the market and follows that without cost, the return for both average passive and average active investment must be the same. This means a higher return by one or a collection of investors must have an equal and direct proportion underperformance by another selection of investors such that at all times the weighted aggregate of returns must be equal to the individual market returns put together. It follows thereafter that with cost the average return of passive investor must be higher than the average return of active investor. The reason for this behavior as explained by Sharpe (1991) is that active managers pay for research on value investments and because active managers are constantly buying and selling stocks, they incur higher transactional cost as compared to passive funds. It follows therefore that if returns are same before cost, then due to higher cost by active fund management, returns will be lower compared to passive.

Despite its popularity elsewhere, one keeps wondering why index funds are virtually unavailable on the Ghanaian market. In a performance comparison by standard and poor (S&P, 2012), it measured active and passive performance in three categories including merged, closed and changed style, and noted in all categories that actively managed funds continue to underperform (Ferri, 2012). Investment fund managers in Ghana have concentrated their investment strategies on buying stocks, based on time and customer risk profile, and speculate on them as well as allocating a significant portion of asset under management to the money market. The focus of this research is therefore to seek a greater understanding and appreciation of the performance of investment fund managers particularly, collective schemes over the last eight (8) years and compare their performance to the Ghanaian Stock Exchange Composite Index (GSE-CI). Sharpe (1991) also makes the point that to effectively measure the performance of an active fund manager, one must identify a comparable passive alternative and measure the performance of the active manager to that benchmark. As much as possible this work has been guided by that.

Looking internationally, it does not take so much effort to appreciate the growing popularity of index fund that is employed by passive fund managers. Indexing as an investment alternative presents a number of advantages and opportunities. Russel investment (2009) think passive investment is becoming popular because investors finds it difficult to deal with the associated risk with active investing and over the years active fund managers have found it difficult to beat the market. Rather than beating the market with associated risk, why not buy the market and achieve market performance. Passive management has shown over the period it ability to operate at a lower cost as against active management that is generally associated with higher management fees and operating expenses. Active fund managers charge their fees on asset as against charging on profit (Costa, 2008) and a calculation by vanguard group shows that over a period of ten years assuming an annual return of 8%, index fund fees will be 3.9% whiles active fund management will charge 33.5% of profit assuming a charge of 2% as annual management fees. Security research and analysis is practically absent with passive investing and this has been one of the main reasons why passive investing is often considered as a low cost investing strategy. Passive strategy also eliminates human errors that are often associated with active investing. It provides transparency as investors rightly know and understand the stock and bonds that makes up the index it tracks.

Despite the advantages, why is it not popular in Ghana? It is generally acknowledged that active investing provide flexibility and risk management and fund managers are better placed to appreciate the market due to the extensive research they conduct on stocks and bonds. Could this be the reason why active fund management is still so popular in Ghana? Even with the advantages of active fund management, many consider any outperformance of active fund managers as random and available data suggest the difficulty to which one can select a good active fund manager. NerdWallet (2013), note that over a 10 year period only 24% of professional investors beat the market with index funds outperforming their active counterparts by 80% annually. “What is consistent with active fund management is that over a continuous period, active funds fail to outperform their benchmark” (Ferri, 2012).

In Ghana, the only widely known index is the GSE composite index and it is a measure of performance of stocks on the GSE. It measures the performance of Ghana’s stock market (Ghana Stock Exchange, 2013). Indexing as an investment strategy is largely unknown and you would hardly find it as a product within the Ghanaian investment environment. However, across the borders to other continents, indexing as an investment strategy has been on the horizon and it is a very popular financial product. A 2014 report by the Investment Company Institute (ICI) affirms the growth of indexing as an investment strategy, and noted that, 372 index funds managed a total net asset of $1.7 trillion by the end of 2013. There is currently limited research work within the Ghanaian environment that focus on the performance of Index returns and active investing and it is hoped that this research work will provide that lead.

1.2 Research Aim

The core aim of this dissertation is to establish and understand the various leading products being offered by selected investment funds companies in Ghana with the purpose of comparing them to the GSE Composite index to establish as a basis for understanding, the performance of fund managers managing such investment funds in Ghana. This will provide empirical data within Ghana regarding the performance of active and passive investment decision and to show whether replicating the GSE Composite index is more superior to Active management. Aside providing an empirical data for fund manager’s performance evaluation, it is hoped to establish comparative basis and guide for individuals and other interested parties when taking decision on how to manage their investable funds.

1.3 Research Questions and Key Hypothesis

Fundamentally, this research seeks to relate the debate of superiority between passive and active investment to the Ghanaian environment and seeks to address the following questions.

Question 1

Would there be any significant difference between buying stock that replicates the GSE composite index and buying investment funds from fund managers in Ghana?

Question 2

Are Investment funds superior alternative to buying stock by way of replicating the GSE

composite index in Ghana? Or to put it differently, are investment fund managers more

efficient way of managing funds compared to buying shares from the Ghanaian stock market?

Question 3

What is the current state of investment funds in Ghana? Are there any index funds on the Ghanaian market?

Thus, in view of the above aims and questions, the research will also aim to examine the following

Key hypothesis: Investing through fund managers in Ghana do not provide higher returns than buying stocks that replicate the market such as the GSE composite Index.

1.4 Dissertation Outline

The dissertation is made up of five main structures and in addition, there is a list of references and appendices all together making up the ending materials.

Chapter one includes an abstract, and a brief introduction to the background of fund management and stock exchange in Ghana. The chapter also include a rational for the study, aims and objective as well as the research question and hypothesis.

Chapter two contains a comprehensive literature review on index fund and investment funds.

Chapter three details the methodology of the research and data collection, validation and likely ethical concerns.

The results of data collection and conclusion are presented in chapters four and five respectively.

CHAPTER TWO

2.1 Literature Review

2.1.1 Background to Index Funds

Hebner (2013) notes that the first index fund masterminded by Rex Sinquefield was established by American National Bank of Chicago though limited to institutional investors with the New York telephone company becoming the first major investor. However, John C. Bogle established vanguard index trust and that eventually became the first index fund available to individual investors.

The vanguard, a pioneer of index fund in a research paper titled "the case for index-fund investing" (2014) argued that since the introduction of index funds beginning of 1970’s, indexing as a form of investment strategy has seen enormous growth. According data sourced from Morningstar, index fund and ETF accounted for about 35% of US equity in 2013. Franklin and Hebner (2014) believe the overall net redemption of $70 billion of actively managed funds on the US stock market were a result of investors moving funds from active management to index and exchange traded funds. Friedman (2014) notes that 10 years ago passive funds accounted for 10% of worldwide equity mutual fund assets and this has grown to about 17% as at 2014. The reason for the growing popularity has been documented by many academic literatures. Common amongst these academic literatures include "low costs, broad diversification, minimal cash drag, and tax efficiency" (Philips and Ambrosio, 2009). Philips and Ambrosio (2009) notes that, unlike price and return which most often has a direct relationship, cost impact on return is rather negative and since most active fund managers incur high cost by way of research and frequent stock trading, it follows that they end up with high cost. The high cost is expressed by way of expense ratio and philips and Abrosio (2009) notes that, amongst market indicators like Alpha, morning star ratings and beta, cost is the only indicator that can be predicted reliably. Given the concept of “zero sum” and the reasoning that before cost the average return of active fund must equal the average return of a passive fund, if cost can be predicted, then it must be that index return will be higher than active returns, all things being equal. Philips and Ambrosio (2009) note that for a mutual fund, cost in the short term may be a small factor due to greater volatility associated with active funds. However at the long run because of the impact of compounding cost factor, active fund tends to trail their benchmarks. This should not be taking to mean however that active managers perform better in the short run. Philips and Ambrosio (2009) makes the point that the short term outperformance of active fund managers may be a result of portfolio construction by way of large, mid and small cap segmentation that may have gone to the advantage of fund managers and may overshadow the higher cost incurred by such a fund manager. Sharpe (1966), Jensen (1968), and Treynor (1965) all have noted the superiority of passive fund performance by way of index fund over active fund.

Philips and Ambrosio (2009) argue that tax gains of index funds may vary depending on the type of index they track. Although an index fund tracking a highly volatile index may not experience so much tax gains as composite of the market index changes frequently, they however note that generally, index funds have the potential to generate favorable tax gains as most often, the composite of index they track generally do not change frequently.

2.1.2 The Active/Passive Debate

The debate to weather active or passive investment has been a long standing one since the introduction of indexing by Vanguard. As far back as 1970, Paul Samuelson (1965) in his theory a “random walk” asserted that market prices provides best estimate of value and future prices and information are unpredictable making prices change randomly leading him to conclude that “Investing should be dull, like watching paint dry or grass grow".

Fisher (2013) also joined the debate by asking whether active verses passive question, the right question to even ask in mutual funds. He observed that over a 15 year period, and using data from morning star, most active managed funds have struggled to beat passive managed funds after adjusting for fees. He established that market do a good job at pricing risk and active fund managers finds it difficult identifying securities that are mispriced. He maintain that it is a very difficult thing to be able the sieve the market information to identify which one has been priced already and which one is not and investors are better off buying an index and not be burden with the task of sieving market information. Coupled with higher expense ratio, which is most often the known and predictable indicator, active fund managers are handicapped right from the beginning. He however advised selection of fund managers with a growth style and also not based solely on low cost. Comparing cost and performance from Equity funds from 1998 up to 2013, he observed that the best performing funds were second when it comes to cost. Interestingly he observed that both the cheapest and the expensive funds where the worst performers. He concluded that the discourse between active and passive fund managers may not be as important to the behaviour of investors. Rather, Fisher (2013) advises investors to stay course with their investment strategy as frequent selling of stock does not allow for the long term equity premium on the stock market, and also notes the high cost of such behaviour. Malkiel (2011) draws attention to this same behaviour of investors and put it that "The consistent losers in the market, from my personal experience, are those who are unable to resist being swept up in some kind of tulip-bulb craze...What is hard to avoid is the alluring temptation to throw your money away on short, get-rich-quick speculative binges".

In his book, the portable private banker, Costa (2011) continued with the debate on active fund management and passive fund management by illustrating with practical allocation of asset to establish the performance of fund managers that he calls ’’best in class” fund managers. He detailed five objective set of criteria to establishing a best in class fund manager including "fund manager transparency, cost transparency, investment strategy transparency, track record, and regular updates. He observed that, it is quite impossible to achieve superior returns in every asset class and market unless fund managers rely on a best in class strategy by selecting specific markets and asset class to which they have core knowledge in. He acknowledged though it is impossible to beat the market, it takes a lot of effort to search for the best in class fund manager that can beat the market. He also noted that, the type of market one is in also plays an important role in determining the type of investment strategy to adopt. He notes for instance that the smaller a market is and if also dominated by the large cap market, the harder it is for a fund manager to beat the market. He again noted the impact of emerging market dynamics like the South America or India market, where several funds outperform their indices. He concluded by advising a combination of indexing and active fund management particular by segmenting markets according to large cap, mid cap or small cap.

2.1.3 Picking Fund Manager with Persistent Performance and the Predictability of Index Funds

In an article titled Investing in Index Funds versus Managed Mutual Funds, Steenwyk (2014) argue that professional fund managers have lost confidence bestowed by the ordinary investor and taking all the fund managers performance together, they just don’t beat the market. He observed that fund managers are only randomly selecting stocks and wondered if fund managers by aggregation actually add value at all. On the assumption that the market is efficient ( efficient market hypothesis), active managers can only randomly pick shares but market price will quickly adjust to reflect available market information there by making it difficult to beat the market consistently and for a very long period. He followed that as a result of flip flopping nature of active fund performance over a long period of years, choosing active fund managers with the ability to outperform in future is almost a guess chance. As Warren buffet (1998) puts it, ‘’Most investors, both institutional and individual, will find that the best way to own common stocks (shares) is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) of the great majority of investment professionals’’. Hemmerling (2012) debunk the notion that active fund managers are able to properly time the market and are able to know when exactly to buy and sell. He noted that, in addition to providing no guarantee, it is difficult to handpick those managers with the ability to properly time the market. This is because active fund managers have shown over the year’s inconsistency with their performance to the extent that, one cannot predict which fund manager will be performing better the next year. Hemmerling (2012) concludes that even though undoubtedly there are smart fund managers, picking a good one is more of an exception than norm.

Cuthbertson, Nitzsche and O’Sullivan (2006) in their paper ”Mutual Fund Performance”, noted that for a period of 20 years assessing mutual fund performance in the UK and the US, only 2-5% outperformed their benchmark with over 20-40% performing poorly. They note that even with the 2-5% top performance there is no evidence of successful market timing. They acknowledged that though past winners persist, the gains are eroded by transactional fees and fund fees with investor gains being marginal. They advised that unless investors attain the skill of sophistication, coupled with great caution, should investors try to pick past winners and pursue an active fund management. Other than that, investors are better off with low cost index funds. Evidence from their research concludes that past losers fund managers remain losers. They note that although in general active fund manager’s exhibit stock picking skills, the outperformance resulting from this is not felt by the investor as management fee

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