What happens when a fund is merged with another?

Recently, I received an email stating that a particular fund called Fund Blue (the merging fund) will be merged to Fund Green (the receiving fund). The rationale is that these two funds are managed similarly and they wish to avoid having two funds running strategies that are nearly identical.  The official reason given for merging the two funds as follows:

The reason why the Board has decided to take this action is because the portfolio manager of the Receiving Fund recently took over the management of the Merging Fund. The Merging Fund and the Receiving Fund have similar investment objectives. As such, in view of the Board’s constant aim to rationalize <asset management company>’s range, and in order to avoid having two funds under the Equity Funds category running strategies that are nearly identical, the Board has decided to merge the assets of the Merging Fund into those of the Receiving Fund. Both funds have the same annual management charge and we anticipate no impact for Shareholders in the Receiving Fund.

According to the Morningstar Global Fund report, the current portfolio manager just took over Fund Blue on 3 October 2014. This same portfolio manager was and is still running Fund Green since November 2008. For those who do not know, the Morningstar Global Fund Reports contain both quantitative and qualitative aspects of funds it monitors but I tend to read it for its qualitative information only.

Impact on staff movement

The following is the performance chart of Blue vs Green and comparing it with their index (shown as Red colour) since 1 November 2008:

One observation from the above is that Fund Green has done very well since 1 November 2008 when this portfolio manager took over this fund. It far outperformed the index. On the other hand, Fund Blue has been tracking the index very closely.  Now that the Fund Green’s portfolio manager has taken over Fund Blue in October 2014, it is time to axe Fund Blue by transferring its assets to Fund Green.

What is survivorship basis?

But a check of the two funds’ performance over a longer period also shows that Fund Blue has been doing extremely poorly compared to Fund Green and the index:

When the merger is completed, Fund Blue will cease to exist and its historical performance will no longer be available. This is known as ‘survivorship bias’  which is a theory that says good performing funds tend to ‘survive’ while the poor performing funds tend to shut down. Without taking into consideration of poor performing funds’ past performance, many investors tend to overestimate the capability of the fund manager.

In my personal opinion, survivorship bias is important for funds that rely on team based approach. For funds that tend to rely on ‘star’ portfolio managers, survivorship bias is not relevant because all past performance is irrelevant anyway once a new ‘star’ portfolio manager takes over.

I believe Fund Green and Fund Blue are run based on ‘star’ portfolio manager approach since the main reason cited for the merger of Fund Blue was attributed to the staff movement of the portfolio manager.

Important tips in investing in unit trusts

In view of the above, here are some things to learn about investing in funds:

1. It is important to ‘monitor’ the unit trusts. One mistake many investors make is to buy and hold the unit trust forever. It is this reason why unit trusts earned itself a very poor reputation. The mass media and many financial institutions incorrectly promote unit trusts as ‘buy and hold (forever)’ tool.
2. Fortunately, monitoring a unit trust is quite simple as compared to stocks. In unit trust, investors just need to monitor its performance relative to other similar peers and watch for staff movement. Monitoring stocks can be a nightmare as it is important to read financial reports, perform financial statement analysis regularly, attend AGM/EOGM and determine whether is the stock still overvalued or undervalued. Of course, it is important to watch for key staff movement of a company too.
3. Unit trusts tend to be a better investment tool for retail investors as their portfolio tends to be small.
4. But I must caution that one also has to monitor the overall asset allocation of the portfolio as market movement could cause one to be overexposed to one country, sector or asset class.

Important tips on index investing

Still, for those who wants to monitor as little as possible can consider index funds since its performance aims to track the index as closely as possible. However, not all index funds are created equal:

1. Some index funds are mainly derivative based while others are ‘physical’ replication. Derivative based index funds are not popular.
2. Watch out for liquidity. For example, recently I have a client who invested in an ETF in a foreign stock exchange on his own. I found the liquidity for the ETF was poor. The daily average turnover over 3 months was SGD 853,183. I found another similar ETF in the same stock exchange that had a daily average turnover over the same period of SGD 7,333,695.
3. The expense ratio of an ETF does not explain all the cost. The tracking error is also important. For instance, an ETF can advertise itself as having an expense ratio of 0.5%pa but its tracking error can be more than 1%pa.
4. Tax issues come into play as well. For the same index tracking ETF, some jurisdictions impose various taxes such as dividend withholding tax, stamp duty charges (for purchase or selling) and hefty inheritance taxes.
5. Custody charges may be imposed by the custodians.
6. An index fund is only as good as the choice of the index. E.g. if an index’s top 5 stock holdings consists of more than 50% of the market capitalisation, there is no diversification benefit in the equivalent ETF that aims to track index.

Related to the last point, one of the main issues in index investing is there is no “upside” to the index fund because it aims to track the index. If the index does ‘badly’, the ETF will also do the same although there were opportunities in the underlying market to do better.

One particular client of mine invested in an ETF since beginning of 2010. She was particularly upset to learn that the ETF did not even breakeven after 5 years. The ETF total return over 5 years with dividends reinvested was -0.74% in SGD. The reason was because the index it tracked did badly. The index was up by a modest 4.79% (total return) also in SGD.  However, it does not mean the underlying market was that bad.  The following chart shows the performance of this ETF in purple compared to its index (black). The yellow and pink charts are the equivalent unit trusts which did much better over the period because there were opportunities to make money in the underlying market.

The question is this: Is it possible to identify the unit trusts in advance that can do better than the index?

(Note: Existing clients whom I am managing their investments can request for the details of the Green, Blue, Red, Yellow, Pink, Black, Purple fund names as well as the Morningstar Global Fund reports mentioned above. I do not wish to reveal the actual names of the funds in public as I do not wish to be seen endorsing or criticising any investment products.)

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