Subscale unit trust funds… what the numbers show

By Trevor Garvin

I recently attended an annual global investment conference in London, where one of the presentations given caught my attention. It covered what they called “Orphan Funds” – funds that had been around for more than 5 years but were subscale in size. I thought it would be worthwhile doing some similar analysis for the South African unit trust market. The outcomes are very consistent with the European fund market.

Too many funds…
There has been a proliferation of new unit trust fund launches in South Africa over the past 5 years – particularly for Regulation 28 compliant funds in the low equity and high equity prudential categories. Many of these funds are sub-scale in size resulting in them not being particularly cost effective. One must assume that they receive attention from their respective fund managers but faced with high running costs and minimal assets – performance has generally suffered. Of course, there are also exceptions to this, with several small funds still delivering some stellar performance figures. 

For our analysis I focussed on subscale funds that have been around for more than three years but have less than R500m in assets under management. This article sets out very broadly the landscape of these subscale funds across the Low Equity Prudential, High Equity Prudential and Domestic General Equity space.

The sub-scale funds landscape
• There were 395 funds that were assessed across the combined Low Equity Prudential, High Equity Prudential and General Equity categories. Together their combined assets make up R1082 billion (over a trillion rand!);
• The 10 largest funds by asset size within each of the 3 categories (or 7.5% of all funds) have a combined value of R758 billion or 70% of the total assets;
• Taking all subscale funds less than R500m in asset size they collectively make up 235 funds (or 59% of all funds) out of the 395 funds. Their combined assets are R51 billion making up 4.6% of the total assets;
• Subscale funds have tended to underperform and have higher annual costs to the investors detriment;
• Subscale funds that have performed the most poorly have also tended to have the smallest amount of assets – indicating that sub-scale funds struggle as the costs impede performance.

Morningstar Fund Ratings explained
Morningstar fund ratings are given to all publicly traded mutual funds. It is a mathematical measure showing how well a funds past performance has compensated an investor for risk taken. Morningstar analysts do not assign star ratings and have no subjective input into the ratings. The calculation considers 3, 5 and 10-year return data where applicable. The top 10% of funds get assigned a 5-star rating, the next 22.5% a 4-star rating, the “middle” 35% a 3-star rating, the following 22.5% a two-star rating and the bottom 10% of funds a 1-star rating.


 
Table 1 above sets out the TOTAL number of funds across the three broad unit trust categories – whether subscale or not. The key take outs from this table could be summarised as follows:
• The ten largest funds across the 3 categories make up the vast amount of assets. These ten funds constitute less than 8% of the number of funds in their category, but make up between 58% and 77% of all assets under management;
• Subscale funds under R500m of assets make up approximately 60% of the number of funds in these categories but less than 6% of the assets under management;
• The average Morningstar Fund Rating across the 10 largest funds is consistently and materially higher than the average Morningstar Rating for funds under R500m in size. This reflects superior long-term risk adjusted returns for investors in the larger funds.
• It is positive to note that most investors have thus achieved better investment returns over the longer term.

The table below focuses ONLY on funds that are less than R500m in size (the “subscale funds”) across the three unit trust categories. The outcomes across all three categories are very consistent.


The key take outs from this table could be summarised as follows:
• The majority of funds show mundane to below average performance. Only between 11% and 26% of the subscale funds have a rating of 4 stars or better, with approximately around 80% of funds showing below average returns;
• The average TER’s across the funds increases as the funds annualised 3-year return performance decreases;
• The average fund size decreases as the funds annualised 3-year return performance decreases;
• Performance differs significantly between the 5-star rated and 1-star rated funds – having a material effect on investors ability to grow their capital.  


If we then AGGREGATE these three subscale fund categories together the results are again consistent. For funds under R500m in size we notice the following patterns or characteristics:
• Only 19% of subscale funds fall within a 4 or 5-star performance rating – compared to the total universe of funds which make up a weighting of 32.5% (see Morningstar Ratings explained); 
• Consistently increasing average TER’s as you move from 5-star rated funds down to 1-star rated funds. Put differently – the worse performing funds have the highest fee cost structures;
• Materially big differences in performance across the spectrum of funds creating large divergence in investor outcomes depending on which funds you have invested into;
• Consistently decreasing average fund size as you move from 5-star to 1-star rated funds. This ties in with the point above – the smaller the fund, the higher the fixed costs resulting in a higher TER, ultimately reducing investment performance.

Finally, just to check from a consistency perspective, we extended the analysis to funds that have been around for 5 years and have assets of less than R200m. The results are set out in the table below.


The key take outs from this table could be summarised as follows:
• The 10 largest funds in the categories make up between 70% and 85% of all the assets, whilst those funds that have less than R200m make up around 1% of total assets;
• Funds under R200m in size make up around 25% of all funds in the categories;
• 5-year annualised returns across the 10 largest funds is materially better than funds under R200m in size – which is confirmed by the average Morningstar ratings across the fund ranges.

Concluding comments
The number of retail unit trusts available in the marketplace has grown rapidly over the past decade with the advent of new asset management houses, the Discretionary Fund Management (DFM’s) industry growing as well as several advisory firms launching their own range of funds. Coinciding with all these new fund launches there has been growing regulation in the industry in terms of Treating Customers Fairly (TCF) within South Africa and the launch of MiFID II (Markets in Financial Instruments Directive issued by the EU to improve protection for investors) in Europe.
This analysis shows that in terms of subscale funds in the South African unit trust landscape, some questions need to be asked in terms of whether the end investor is getting a fair deal. High costs, small fund sizes and poor investment performance seem to be commonplace – if we as an industry are to take our stewardship role responsibly then these issues need to be addressed. Creating positive investor experiences is so important for the industry to continue to flourish and ultimately for people to retire with peace of mind. Results are consistent across both a 3 and 5-year time horizon, as well as between funds under R200m or R500m in size. Finally, one does need to also recognise that there are some funds that although small, have performed consistently over time and delivered on their mandate – they need to be commended.

Source: All data for fund tables was taken from Morningstar Direct as at 31 March 2019.