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What risk are they managing?

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What risk are they managing?

One of our peeves at Montgomery is fund managers who ‘hug’ the index. A manager might for example take an underweight position in BHP by allocating 5 per cent of a portfolio to it, when BHP makes up around 7 per cent of the index. This leaves them with a 2 per cent underweight position, which can fund an overweight position in some other large cap stock. If they charge investors a fee of 100 basis points for this type of ‘active’ management, the investors are getting a raw deal. The fee applies to the entire amount of funds invested, but only 2/7ths of that amount is invested differently to the index. The effective cost for that 2/7ths starts to look pretty steep.

Managers like to manage positions around index weights because it reduces ‘risk’. But what is the risk that is being reduced?

In our view, it is mostly career risk for the fund manager. If your portfolio is not far from the index then you can’t underperform by very much. That means you are unlikely to lose a lot of clients in a run of bad luck, and unlikely to get fired.

In our view, active managers are paid to take career risk, and owe it to their clients to do so. Investing in bad companies simply because they are large is a cop out.

Rant ends.

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Tim joined Montgomery in July 2012 and is a senior member of the investment team. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Tim focuses on quant investing and market-neutral strategies.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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6 Comments

  1. I really don’t mind if the herd follow the index, just makes it easier for you and me to make money. Keep up the good work, (which continues to make me richer).

  2. No Index hugging going on here. Congrats to the Montgomery team for another stellar year, looking forward to another outperformance year in 2015.

    All the best

    Scott T

  3. Index hugging frustrates me to no end. The portfolios we use for clients, inclusive of Montgomery, all target the preservation of capital by sitting in the safety of cash until great undervalued businesses can be found. Paying active management fees for the managers we use is absolutely worth it, whereas the same can’t be said for the mainstream index hugging managed assets on the market. Keep up he good work Roger and team.

  4. Great rant Tim – its unbelievable that this is the way most fund managers operate.

    I still remember my days as an intern at a funds management firm. First being subject to the sales pitch given to most clients about the amazing ‘4-step’ stock picking process, then finding out gradually over the coming months that the pitch and the reality weren’t even remotely related, and then finding out the truth about how the funds are actually invested (i.e. index hugging).

    There needs to be wider discussion around this, particularly education to the wider public who have no idea about this practice.

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