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SCMP Reporter

ARE a lot of Hong Kong's fund managers hiding in the closet? The question has nothing to do with their private lives but rather with the way they invest their clients' money.

 Broadly speaking, mutual funds can be broken into two types: actively managed ones and index trackers.

 Active fund managers reckon to spot stocks, trends, sectors and indexes that offer undiscovered value. They then load up and, if all goes well, outperform their rivals.

 Index-fund managers - who seek to track the relevant benchmark, no better or worse - doubt whether the active managers' tactics work. There is much evidence that, in the long run, active managers underperform their benchmarks.

 So the index trackers figure it makes more sense just to create portfolios that replicate the benchmark. Because that kind of portfolio is easier and less costly to run, investors in tracker funds should not have to pay high up-front fees - also known as front-end loads - or hefty annual management charges.

 Then, there is a breed in between. These managers claim to be actively managing their funds - and charging handsomely for it - but, in fact, build portfolios that largely match the weightings of stocks in their market's index. These are the 'closet' trackers.

 A look at the portfolios of funds invested in the Hong Kong stock market shows that many of them could qualify for the closet title. Managers of these funds might not be replicating the Hang Seng Index exactly - HSBC Holdings' hefty weighting rules that out - but their investments bear a remarkable resemblance to its constituents. And to each other.

 The top 10 holdings of the 20 biggest funds investing in Hong Kong are remarkably similar, according to data from fund-tracking company Lipper Analytical Services Asia. Cheung Kong (Holdings), HSBC, Hutchison Whampoa and Sun Hung Kai Properties dominate the portfolios, followed closely by China Telecom (Hong Kong) and Hang Seng Bank.

 Only 16 stocks show up in the top 10 holdings of the 20 largest Hong Kong funds (excluding our two officially declared index funds and Value Partners' small-capitalisation funds, which by definition do not invest in the big companies that make up the index).

 Even other blue chips, such as New World Infrastructure and Swire Pacific, appear only once in the list of holdings.

  Some of the braver funds have bought such companies as Johnson Electric Holdings or SmarTone Telecommunications, but the majority follow the short list of favourites.

 The debate on the merits of actively managed funds versus index trackers has been fired in the past couple of years by the solid performance of big-cap stocks in the United States.

  This has given a real edge to funds that track the Standard & Poor's 500-stock index. Meanwhile, smaller companies, which should be providing exciting growth, have been ignored - with the notable exception of high-flying Internet stocks.

 In Britain, the subject became white hot earlier this year with the unofficial publication of the findings of a study carried out on behalf of the Financial Services Authority. The study detailed how active fund managers had underperformed their benchmarks - and still charged royally. At the same time, many British funds have been edging into the closet so as not to lag too far behind the major indexes.

 The same thing has been happening in Hong Kong, says the managing director of Value Partners, Cheah Cheng Hye. And he warns this might prove a dangerous trend.

 'Hong Kong's money-management industry is dominated by disguised index funds,' he said. 'Discussions today always focus on Hutchison, HSBC, Cheung Kong and Hongkong Telecom. There is not much value-added we can bring to those four stocks. Trading is efficient, and we don't have any insights that other people don't have.'  As layoffs shrink staffs, those who remain face larger workloads, and that means fund managers are relying more on brokers' research, which tends to focus on big-cap stocks. And the layoffs themselves have concentrated the minds of the survivors.

 'They cannot take the risk of going outside the index. If they underperform, their job is at stake,' Mr Cheah said.

 The Government's massive market intervention last year accelerated the move into the bluest of the blue. The Government bought large caps and added to their momentum, leaving small companies out in the cold.

 Mr Cheah warns that this trend could be bad for Hong Kong's role as a financial centre.

 'There are more than 600 stocks quoted in Hong Kong, but less than 10 are capturing all the fund managers' money. So the others are just starving. How are we going to develop the equities market from here on?' he said.

 Another danger Mr Cheah sees is mob mentality. If there was a sudden shake-out in the market, all the funds might end up trying to dump the same stocks at the same moment, with obvious results.

 For investors, the question must be: why pay high active-manager fees to a closet tracker? Most of the big funds covered by Lipper have nominal front-end loads of 5 per cent, with the exception of Manulife Funds Direct's official tracker, which is a no-load fund.

 If the market is really all about a handful of stocks, then direct investing would not be too big a problem. If that caught on, some managers might have to come out of the closet and compete on charges rather than doubtful promises of performance.

Ray Heath is pleased to receive general enquiries about investing in funds, but he cannot offer investment advice or recommendations.



Investors pay unacceptable price to closet index trackers