CHAPTER 4

FUNDS MANAGEMENT
Topics
4.1

Superannuation funds

4.2

Insurance policies

4.3

Public unit trusts

4.4

The principles and approaches of investment

management

4.5

Investment management performance

LEARNING OBJECTIVES
Describe the operation of superannuation funds
Explain the financial characteristics of life and
general insurance companies
Describe the main forms of collectiveinvestment vehicles
Explain the principles and approaches of
investment management
Explain the principles of assessing the
performance of investment manager

INTRODUCTION
Fund managers pool investors funds and
arrange their collective investment
they contribute to the flow-of-funds through
direct financing
The funds belong to the individual (mainly
retail) investors, who receive the investment
returns less fees paid to the fund manager
the investment risk remains with the
contributor

INTRODUCTION continued
The main groups of fund managers are
superannuation, life insurance and public unit
trusts

INTRODUCTION continued
Fund management comprises:
1.

the collection and administration of retail

investors funds, and

2.

the investment of the pooled funds

The main asset classes for investment are:

Equities
and units
in trusts

Interestearning
securities

Cash and
deposits

Overseas
assets

Alternative
investments

4.1 SUPERANNUATION FUNDS

Superannuation is a long-term savings scheme
that aims to generate retirement income from
contributions made during a persons working
life. It is compulsory in Australia.
Most are accumulation schemes which
produce a lump sum that depends upon the
size of contributions and the rate of earnings
on their investment
Whereas defined benefit schemes commit
to pay a specified benefit (either as a lump
sum or pension) to the retiree

4.1.1 THE STRUCTURE OF

ACCUMULATION SCHEMES

The amount accumulated by retirement

depends on the amount of the contributions,
the compounding (reinvestment) of returns
and the rate of return earned

IMPACT OF COMPOUNDING
Returns in superannuation funds compound
because they cannot be withdrawn prior to
retirement
Observe the impact of compounding returns on
$100
at 10% pa:
Term invested
Accumulated
value
Incremental
10
years
20
years
30
years
40

$100 1 0.1

10

$259.37

interest
$159.37

$100 1 0.1

20

$672.75

$413.38

$100 1 0.1

30

$1744.94

$1072.19

$100 1 0.1

40

$4525.93

$2780.99

IMPACT OF EARNINGS
The accumulated sum depends much more on
compounding and the rate of return than on the
amount of the contributions
Compare the accumulated sum from
contributions of $200 per month for 40 years
with average returns of 7% and 10%pa:
1 0.07 4012 1
12
$524963
Futuresum7% 200
0.07

12

1 0.1 4012 1
12
$1264816
Futuresum10% 200
0.1

12

INVESTMENT RETURNS
The return on superannuation assets is volatile
and so poses investment risk for contributors

ASSET CLASS RISK & RETURNS

Returns earned depend on the mix of assets in
which the funds are invested
Growth assets
these are equities and property securities
(both local and international) that are
relatively high risk/high return assets
Defensive assets
low risk/low return assets including bonds,
bank deposits and money market securities
rarely experience negative returns

INVESTMENT STRATEGIES
Usually superannuation funds provide
contributors with a choice regarding asset
class portfolios
Most commonly:
Balanced portfolios hold a mix of
investments that comprise a similar
proportion of defensive assets and growth
assets, whereas
Growth portfolios comprise more high
risk/high return assets (equities and
property) and smaller amounts of defensive
assets

4.1.2 THE SUPERANNUATION

INDUSTRY
The industry is comprised of:
1.

Not-for-profit schemes established by:

employers, categorised as corporate or
public service schemes
trade unions, categorised as industry
schemes

2.

For-profit schemes established by professional

fund managers
known as retail schemes

3.

There are also many self-managed funds

(SMSFs)

TRUSTEES
The managed superannuation schemes are
constituted as trusts
The trustee ensures the investment manager
allocates funds according to each contributors
choice and in a manner consistent with the
trust deed for the purpose of maximising the
accumulated sum
Trustees
have a fiduciary duty of care to the
schemes members
are licensed and supervised by APRA

SUPERANNUATION FUND DATA

Retail schemes have historically achieved

lower returns due mainly to their higher fees

4.1.3 SELF-MANAGED
SUPERANNUATION FUNDS
There are over 500 000 SMSFs (as at June
2013)
Most operate under rules set by the Australian
Tax Office
Assets in the fund are managed by the
contributor
Compared to managed funds, they invest
less in equities (approx. 32%) and
more in bank accounts (approx. 30%)
About 20% of assets are invested in managed
funds

4.2 INSURANCE POLICIES

Insurance policies are risk-transfer instruments
that also perform the flow-of-funds function
Policyholders are prepared to pay premiums
to insurance companies for them to accept
various risks
payments to policyholders are contingent
upon the occurrence of the insured event
and so the insurance company incurs a
contingent liability

INSURANCE COMPANIES
Insurance companies are prepared to sell
policies (known as insurance underwriting)
because they expect the premiums will exceed
their costs and payouts
They pool premiums and invest in assets to
generate income and to form reserves to meet
their future obligations
they face investment risk on these assets
Policies are designed to reduce the risks posed
by moral hazard, adverse selection and
fraudulent claims

4.2.1 LIFE INSURANCE

Most are term
life policies
these pay the
insured sum to
the beneficiary
only in the
event of the
policyholders
death during the
policys term

Most policies are

held as part of
superannuation
schemes to provide
income to the
contributors
beneficiary (in the
case of the death)
or to the contributor
(in the event of a
permanent
disability)

4.2.2 GENERAL INSURANCE

These cover a wide range of events that inflict
losses, and provide financial compensation if
an insured event occurs
Examples of general insurance are:
house and contents insurance
motor vehicle and third-party insurance
travel insurance
Reinsurance is used by general insurance
companies to spread their payout risks

4.3 PUBLIC UNIT TRUSTS

ASIC regulated collective investment schemes
that raise funds by selling units to the public,
which represent a share of their assets
The pooled funds are allocated by the trusts
investment manager to assets specified by the
trust deed, subject to a trustees oversight
They are usually established by financial
institutions to earn fees
entry/exit fees and ongoing management
fees

BENEFITS OF PUBLIC UNIT TRUSTS

Public unit trusts provide investors with:

access to wholesale financial markets

the expertise of professional portfolio

managers

The trusts provide liquidity:

1.

by buying units from, and selling units to

investors at their bid and offer prices, from
which they earn a spread, or

2.

through their listing of units on the ASX

(ETFs)

TYPES OF COLLECTIVE INVESTMENT

Collective
investments
Traditional public unit
trusts

Alternative
investments

Property

Hedge funds

Equity

Private equity
funds

4.3.1 TRADITIONAL PUBLIC UNIT

TRUSTS
Property trusts
Established by financial institutions or property
developers to acquire large properties such as
shopping centres
Most are ASX listed
They are usually close-ended meaning they
have a set number of units
Unit holders receive the propertys revenues
less fees
Trusts use debt funds, exposing unit holders to
interest rate risk and funding risk

4.3.1 TRADITIONAL PUBLIC UNIT

TRUSTS
Equity trusts
Invest in shares listed on major
exchanges
Have a variety of specialised
investments or objectives (income,
balanced, growth)
Are generally open-ended
Are usually unlisted

ALTERNATIVE INVESTMENTS
4.3.2 Hedge
funds
Pooled investment schemes that use a
wide range of complex investment
strategies and very high levels of debt
They charge on-going management fees
and performance-linked fees
Mostly US based where the managers are
very aggressive seeking high returns
and taking large risks

ALTERNATIVE INVESTMENTS

4.3.2 Hedge funds

strategies
Became known as hedge funds because
they aimed to protect investors from loss
when market prices are falling
The strategies they use include
long/short strategy, derivatives and
program/high frequency trading

ALTERNATIVE INVESTMENTS
4.3.2 Hedge funds in
Australia
The hedge fund industry is relatively small
in Australia
They are ASIC regulated and must
inform investors of their investment plans
and fees
Funds of hedge funds (FOHFs) seek to
reduce investor risk by investing in a
range of hedge funds, they hold about
of hedge fund assets in Australia but
impose an additional set of fees

ALTERNATIVE INVESTMENTS
4.3.3 Private equity
funds
Acquire companies for the purpose of
improving their financial performance and
reselling them at a profit
Formed by specialist PE firms that act as
the funds controlling partner with equity
funds raised from wealthy individuals and
institutional investors
The funds use large levels of debt (LBOs)
Investments lack liquidity

4.4.1 THE BENEFITS OF COLLECTIVE

INVESTMENT
Access to
wholesale
investments

Economies of scale that

lower transactions costs,
such as research and
trading commissions

Diversified investments that

lower risk for an expected
rate of return

Investment
expertise

4.4.2 APPROACHES TO INVESTMENT

MANAGEMENT
Active
investmen
t
managem
ent

Not consistent with EMH

Seek to outperform the market
through asset selection and timing
of trades
Higher costs

Passive
investmen
t
managem
ent

Consistent with EMH

Seek to form index funds that aim
to replicate the return on a
benchmark index
Lower costs

4.4.2(a) ACTIVE INVESTMENT

MANAGEMENT
Active management seeks to achieve above
average returns that is, higher than those of
competing managers and the market
They need to be able to identify assets that
are under or over-valued
they buy the former and sell the latter
The two main methods of assessing asset
value are technical analysis and
fundamental analysis

TECHNICAL ANALYSIS
Examines historical data (charts) to predict
future asset price movements
Underlying technical analysis is the idea of
persistent price trends and cyclical price
patterns, which if identified, will reveal when to
buy & sell

Analysts try to identify price channels, price

support & resistance lines and momentum
indicators

Evidence of consistent above-average returns is

not strong nonetheless it is widely used in the
investment industry

SENTIMENT-BASED STRATEGIES
Momentum investors
believe prices take
time to move to their
new fair values
following the release
of new information
They would buy
when a price began
to rise , expecting
the price will
continue to rise
and vice-versa

Contrarian
investors believe
markets overreact
to good and bad
news
They will buy when
prices fall (believing
prices have fallen too
much) and sell when
prices rise (assuming
they have risen too
much)

FUNDAMENTAL ANALYSIS
Attempts to
calculate an
assets value as
the present
value of its
expected future
payments

This is then
compared to the
current price
overpriced assets
would be sold,
underpriced assets
bought or retained

Fundamental analysis can include market &

industry analysis, financial statement analysis
and discounted cash-flow analysis

4.4.2(b) PASSIVE INVESTMENT

MANAGEMENT AND INDEX FUNDS
These managers form a portfolio (an index fund)
that replicates the returns achieved by a
benchmark index, such as the ASX200
They invest in assets in proportion to their role in
that index

or, (to lower costs) hold fewer shares and

accept a small tracking error in the portfolios
returns
The management expense ratios (MER) of
passive funds is generally half those of active
funds

4.5 INVESTMENT MANAGEMENT

PERFORMANCE
The performance of fund managers should
be assessed in terms of the returns
achieved given the risks taken
and comparisons made between
managers in the same asset class
But fund returns are unstable, and past
returns are not usually a good indicator of
future returns hence the need for fund
ratings agencies

4.5.1 RATINGS OF INVESTMENT

MANAGERS
Managers are rated on the basis of their
quantitative risk and return history and a
qualitative assessment of the managers abilities
S&P use a five-star rating scale, where 3 stars
indicates an expectation of average returns, 1
or 2 of below average returns, and 4 or 5 of
above average returns
Morningstar also use a five-star scale, you
can check out their ratings at http://
www.morningstar.com.au/Funds
Ratings influence the allocation of investments
between active managers

RETURN PERSISTENCE
Research indicates that higher-rated managers
can continue to outperform, but not consistently

4.5.2 THE PERFORMANCE OF ACTIVE

VERSUS PASSIVE INVESTMENT
Many studies provide
evidence that passive
funds have achieved higher
after-fees returns than
actively managed funds

But sometimes an active

manager can outperform
for a number of years, or
within a particular asset
class (such as investments
in small firms)

REVIEW OF LEARNING OBJECTIVES

Describe the operations of superannuation
funds
Superannuation funds manage lifelong savings to
build assets that provide retirement incomes
Superannuation is compulsory in Australia with
most assets held in managed funds and the
balance in SMSFs
The accumulated sum is very sensitive to returns
achieved

Explain the financial characteristics of

insurance policies
General insurance can cover a range of insured
events
Life insurance provides life and disability policies

REVIEW OF LEARNING OBJECTIVES

Describe the main forms of collective
investment
Public unit trusts (listed and unlisted) are the
foremost collective investment vehicles and mainly
invest in equity and property
Hedge and private equity funds are alternative forms
of collective investment that use non-conventional
investment strategies and high levels of debt

Explain the principles and approaches of

investment management
The benefits of funds management are access to
wholesale investments, lower investment costs,
diversified investments and expertise

REVIEW OF LEARNING OBJECTIVES

Active managers seek above-average returns and
employ fundamental, technical and sentiment-based
analysis
Passive managers mainly seek to match the returns
of an benchmark index by constructing index funds

Explain the principles of assessing the

performance of investment managers
Performance should be assessed on return
performance subject to the risks taken
Ratings agencies assess the abilities of fund
managers
The evidence suggests index funds generally (but not
always) out-perform active managers