Since I got into, well, not exactly an argument, but at least a rather heated discussion over this topic on the LYN forums, I thought it might be interesting to write down a summary of my posts there and also what I’ve learned from that thread. Please note that all of this mostly applies only to Malaysia.

Now I’m just a neophyte investor and I don’t make any claims to exceptional knowledge or skill. But I do take care to read through the basics and try to educate myself in whatever it is I’m getting into. One of the most basic and well known ways to invest your money is through the stock market. You can either do it yourself, picking stocks that you personally believe will do well and pray, or you can entrust it to “professional” mutual fund managers and pray. I’m guessing that most working people don’t have the time or inclination to actually do their own research and will opt for the latter. That’s what I did and this is where things get interesting.

Most people should know that there are basically two types of mutual funds that invest in equities. On the one hand, you have the traditional equity funds which promise you that they have the smartest and most knowledgeable money managers who are supposedly able to predict which stocks are going to be winners and thereby beating the market. The problem is that they charge you a ton of fees for the privilege of deploying their skills on your behalf, alpha in the industry jargon, but cannot guarantee performance. On the other hand, you have the index funds which explicitly do not promise alpha at all. Instead, index funds attempt to closely track its underlying benchmark and rely only on beta, or the prevailing market sentiment, to make money. Since index funds don’t need to pay for pricey researchers, analysts and other such “talent”, their fees tend to be significantly lower than normal equity funds.

As unsexy as index funds sound, by now there’s a wealth of academic research demonstrating that by and large the average do better by placing their money in index funds than traditional equity funds. Take this article for example:

Expenses were the culprit. For both the actively managed fund and the hedge fund, those expenses more than ate up the large amounts — 3.5 and 9 percentage points a year, respectively — by which they beat the index fund before expenses.

IF such outperformance isn’t enough to overcome the drag of expenses, what would do the trick? Mr. Kritzman calculates that just to break even with the index fund, net of all expenses, the actively managed fund would have to outperform it by an average of 4.3 percentage points a year on a pre-expense basis. For the hedge fund, that margin would have to be 10 points a year.

The chances of finding such funds are next to zero, said Russell Wermers, a finance professor at the University of Maryland. Consider the 452 domestic equity mutual funds in the Morningstar database that existed for the 20 years through January of this year. Morningstar reports that just 13 of those funds beat the Standard & Poor’s 500-stock index by at least four percentage points a year, on average, over that period. That’s less than 3 out of every 100 funds.

Now I realize that research findings based on US capital markets aren’t necessarily relevant to Malaysia. Our stock market has too few players involved in it and has too short a history, making it impossible to verify that the same findings are true locally. I suspect that other relevant factors are that publicly traded companies represent too small a fraction of the national economy and that regulatory filings give a far truer picture of the state of the company in the US than in Malaysia. Even so, surely it’s worth to take a look at the index funds available here?

So let’s start off with the largest mutual fund company in Malaysia, Public Mutual Berhad. It does have an equity fund called Public Index Fund (PIX) but look closer and you’ll see it’s not really an index fund at all. It charges an initial buy-in fee of 5.5% and an annual management fee of 1.5% which is exactly the same as the other equity funds it manages, for example, the Public Equity Fund (PEF). In fact, if you look at its prospectus, you’ll see that it claims that PIX is not an index fund at all but an actively managed equity fund with the explicit objective of outperforming its benchmark KLCI. So much for the name. This is annoying to me because when I asked about whether or not the company had any index funds, one LYN poster who also happens to be a sales agent for Public Mutual actually directed me to PIX.

Another LYN poster more helpfully pointed me towards the OSK-UOB KLCI Tracker. This one has the objective of closely corresponding to the performance of the KLCI and actually includes information on the methodology it uses to track its benchmark and warns of potential tracking errors that may happen. Now that’s more like it! Except when you look at its fees and realize that it imposes a 1% buy-in charge, a 1% redemption charge and most importantly a 1.5% annual management fee, exactly the same as the PIX. It may have lower buy-in costs, but given that it shouldn’t need to pay for researchers and analysts, surely we should get a bigger discount than that?

For the sake of comparison, one of best known index funds in the US, the Vanguard 500 Index Fund, charges no purchase or redemption fees and an annual management fee of only 0.15%. This indicates that the so-called index funds in Malaysian are extremely expensive. More interestingly, it suggests that the “premium” for buying talent to actively manage a fund is extremely cheap. Given this fact and the previously mentioned reasons why passive indices might not be as efficient in Malaysia, I think it’s an interesting question whether or not these index funds are really worth it.