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Theses

2006

Factors influencing unit trust performanceCheong Sing TngSouthern Cross University

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Publication detailsTng, CS 2006, 'Factors influencing unit trust performance', DBA thesis, Southern Cross University, Lismore, NSW.Copyright CS Tng 2006

FACTORS INFLUENCING

UNIT TRUST PERFORMANCE

Tng Cheong Sing

B.Sc. (Hons) Lond, MFM CQU

A thesis submitted in partial fulfilment of

requirements for the Degree of

Doctor of Business Administration

Southern Cross University

Graduate College of Management

July 2006

ii

Statement of original authorship

This thesis has been prepared in accordance with the rules set out for the Degree of Doctor

of Business Administration at Southern Cross University. The work presented in this thesis

is, to the best of my knowledge and belief, original, except as acknowledged in the text.

The material has not been submitted, either in whole or in part, for a degree at this or any

other university.

Tng Cheong Sing

July 2006

iii

Acknowledgements

Special thanks to Dr. Geoffrey Meredith, AM (Emeritus Professor, Southern Cross

University) for his professional supervision of this research. Dr. Julia Sawicki (Assistant

Professor, Nanyang Technological University), Dr. Koh Seng Khee (Associate Professor,

Singapore Management University) and Dr. Teo Cheng Swee (Adjunct Professor,

Southern Cross University) provided helpful comments on initial drafts of this thesis. Mr

Andrew Kwek (executive director, Investment Management Association of Singapore) and

Ms Teo Jing Ling (administrative officer, Central Provident Fund Board) answered queries

about unit trust data.

For helpful comments and suggestions, I gratefully acknowledge Southern Cross

Universitys DBA workshop participants and University of Tasmanias research seminar

participants, as well as participants at the Academy of International Business Southeast

Asia Regional Conference, Australasian Finance and Banking Conference, International

Business Research Conference and Waikato Management School Student Research

Conference.

Mercer Investment Consulting and S&P Fund Services Asia provided secondary data. Data

entry assistants were funded by the School of Accounting and Finance, University of

Tasmania.

iv

Abstract

Bank-managed equity funds are not inferior to their non-bank counterparts. Previous

research reporting relative underperformance of bank-managed funds ignored their

differing fiduciary standards. To evaluate bank and non-bank funds facing similar

fiduciary responsibilities, domestic retail funds approved for Singapores Central

Provident Fund Investment Scheme were examined, as they meet the same standard for

managing social security savings. Returns from these funds correlate highly with market

performance. Even though these fund returns exceeded guaranteed interest rates, they did

not outperform their market index.

With financial market deregulation in Southeast Asia, local banks in small economies

withstand erosion of business by foreign competitors. Banks, in order to increase profits,

compete with local as well as foreign insurance and investment companies by offering

mutual fund products. To remain competitive, banks need to shed their reputation for not

being able to generate impressive fund returns, as their funds are not inferior to those from

insurance and investment companies in terms of assets under management, expenditures,

returns and risk. To gain competitive advantage, banks can differentiate their fund

characteristics and reduce portfolio management costs.

Mutual fund characteristics can affect expected returns or transaction costs. Factors

affecting expected returns include asset allocation and systematic risk, while transaction

costs include explicit and implicit ones, which can be measured by expense ratios and size

of funds respectively. Insignificance of transaction cost determinants in affecting actual

returns can be attributable to dominance of factors affecting expected returns.

v

Keywords

Assets under management

Bank-managed fund

Expense ratio

Financial institution

Fund performance evaluation

Mutual fund management

Unit trust

vi

Presentations and publications

Tng, C 2005, 'Sustainable development of bank-managed mutual funds: evidence from

Singapore's retail funds', paper presented at 9th Waikato Management School

Student Research Conference, University of Waikato, 25 October (Appendix B, pp

194-206).

Tng, C 2005, 'Performance of approved equity funds: evidence from Singapore's retail

funds', paper presented at 18th Australasian Finance and Banking Conference,

Sydney, 14-16 December (Appendix C, pp. 207-221). Drafts presented at Graduate

College of Management DBA workshop, Southern Cross University (13-15 May)

and School of Accounting and Finance Research Seminar, University of Tasmania

(19 August).

Tng, C 2007, Effects of expenditures and size on mutual fund performance, Singapore

Management Review/Asia-Pacific Journal of Management Theory and Practice,

vol. 29, no. 1 (Appendix D, pp. 222-232). Paper presented at School of Business,

Monash University Malaysia campus, 10 July 2006. Draft presented at 2nd

International Business Research Conference, University of Technology Sydney, 5-

8 December 2005.

Tng, C 2007, Bank fund management challenges and opportunities being reviewed by

Singapore Management Review/Asia-Pacific Journal of Management Theory and

Practice (Appendix E, pp. 233-243). Draft presented at Academy of International

Business Southeast Asia Regional Conference, Manila, 24-26 November 2005.

vii

Table of contents

Statement of original authorship ........................................................................................................ii Acknowledgements ...........................................................................................................................iii Abstract ............................................................................................................................................. iv Keywords ........................................................................................................................................... v Presentations and publications ..........................................................................................................vi Table of contents ..............................................................................................................................vii List of tables....................................................................................................................................... x List of figures ....................................................................................................................................xi List of equations...............................................................................................................................xii Abbreviations ..................................................................................................................................xiii Glossary...........................................................................................................................................xiv Chapter 1 Research overview............................................................................................................. 1

1.1 Introduction.............................................................................................................................. 1 1.2 Background to the research...................................................................................................... 3

1.2.1 Nature of mutual funds ..................................................................................................... 3 1.2.2 Challenges facing mutual funds ....................................................................................... 4

1.3 Research problem and questions.............................................................................................. 5 1.4 Definitions ............................................................................................................................... 7 1.5 Methodology............................................................................................................................ 8

1.5.1 Data collection.................................................................................................................. 8 1.5.2 Statistical analysis............................................................................................................. 9 1.5.3 Model validation............................................................................................................... 9

1.6 Assumptions and delimitations ..............................................................................................10 1.6.1 Assumptions ................................................................................................................... 10 1.6.2 Delimitations .................................................................................................................. 13

1.7 Thesis plan ............................................................................................................................. 14 1.8 Conclusion ............................................................................................................................. 14

Chapter 2 Background and research justification............................................................................. 16

2.1 Introduction............................................................................................................................ 16 2.2 Background to the research problem ..................................................................................... 17

2.2.1 Singapores demographic characteristics ....................................................................... 17 2.2.2 Demography of Singapores asset management industry............................................... 18 2.2.3 Equity, bond, balanced and money market funds........................................................... 19 2.2.4 CPF-approved and non-CPF-approved unit trusts.......................................................... 21 2.2.5 Risk classification of unit trusts...................................................................................... 22 2.2.6 Fee structure of unit trusts .............................................................................................. 24 2.2.7 Regulation of unit trusts ................................................................................................. 25

2.3 Performance of unit trusts in Singapore................................................................................. 27 2.3.1 Fund performance from 1976 to 1994............................................................................ 28 2.3.2 Fund performance from 1999 to 2003............................................................................ 30 2.3.3 Performance of CPF-approved unit trust investors ........................................................ 31

2.4 Contribution of the research................................................................................................... 32 2.4.1 Mutual fund performance model .................................................................................... 32 2.4.2 Conference presentations and article publications ......................................................... 32 2.4.3 Research outcomes for finance teachers and researchers ............................................... 32

viii

2.5 Justification for the research .................................................................................................. 33 2.5.1 Gaps in the mutual fund literature .................................................................................. 33 2.5.2 Research approach.......................................................................................................... 34 2.5.3 Benefits for Singapores unit trust industry.................................................................... 34

2.6 Conclusion ............................................................................................................................. 34 Chapter 3 Literature review.............................................................................................................. 36

3.1 Introduction............................................................................................................................ 36 3.2 General theories relating to mutual fund performance .......................................................... 37

3.2.1 Efficient market theory................................................................................................... 37 3.2.2 Mutual fund performance ............................................................................................... 38 3.2.3 Measurement of mutual fund performance..................................................................... 41 3.2.4 Asset pricing theories ..................................................................................................... 45

3.3 Determinants of mutual fund performance ............................................................................ 48 3.3.1 Asset allocation............................................................................................................... 50 3.3.2 Investment style.............................................................................................................. 51 3.3.3 Risk................................................................................................................................. 52 3.3.4 Past performance and performance persistence.............................................................. 52 3.3.5 Flow of funds and assets under management ................................................................. 54 3.3.6 Research and trading costs ............................................................................................. 56 3.3.7 Type of fund management company .............................................................................. 57

3.4 Theoretical framework........................................................................................................... 59 3.4.1 Mutual fund performance models................................................................................... 60 3.4.2 Research issues and propositions.................................................................................... 63

3.5 Conclusion ............................................................................................................................. 67 Chapter 4 Research methodology .................................................................................................... 70

4.1 Introduction............................................................................................................................ 70 4.2 Research approaches.............................................................................................................. 71

4.2.1 Case research .................................................................................................................. 72 4.2.2 Survey research............................................................................................................... 75 4.2.3 Secondary data research ................................................................................................. 77 4.2.4 Justification for research using secondary data .............................................................. 79

4.3 Research design ..................................................................................................................... 81 4.3.1 Hypothesis testing........................................................................................................... 81 4.3.2 Non-causal investigation ................................................................................................ 81 4.3.3 Minimal researcher interference..................................................................................... 82 4.3.4 Non-contrived setting ..................................................................................................... 82 4.3.5 Fund management institutional group as unit of analysis .............................................. 82 4.3.6 Longitudinal time horizon .............................................................................................. 82

4.4 Data collection ....................................................................................................................... 83 4.4.1 Data collection methods ................................................................................................. 83 4.4.2 Downloading of financial data from online sources....................................................... 83

4.5 Data analysis .......................................................................................................................... 86 4.5.1 Regression analysis......................................................................................................... 86 4.5.2 Hypothesis testing........................................................................................................... 87

4.6 Research quality..................................................................................................................... 88 4.6.1 Internal validity............................................................................................................... 89 4.6.2 External validity ............................................................................................................. 92

4.7 Ethical considerations ............................................................................................................ 93 4.7.1 General ethical issues ..................................................................................................... 93 4.7.2 Specific ethical issues..................................................................................................... 94 4.7.3 Independent academic research to avoid ethical lapses.................................................. 94

4.8 Conclusion ............................................................................................................................. 95

ix

Chapter 5 Data analysis.................................................................................................................... 96 5.1 Introduction............................................................................................................................ 96 5.2 Characteristics of domestic equity funds ............................................................................... 97

5.2.1 Fund management company........................................................................................... 97 5.2.2 Returns............................................................................................................................ 98 5.2.3 Beta............................................................................................................................... 100 5.2.4 Expense ratio ................................................................................................................ 101 5.2.5 Fund size....................................................................................................................... 103

5.3 Regression analysis.............................................................................................................. 104 5.4 Hypothesis testing................................................................................................................ 105

5.4.1 Performance of domestic equity funds ......................................................................... 105 5.4.2 Performance comparison of bank and non-bank funds ................................................ 110 5.4.3 Expenditures, size and performance of domestic equity funds .................................... 115 5.4.4 Comparison of bank and non-bank fund characteristics............................................... 117

5.5 Conclusion ........................................................................................................................... 120 Chapter 6 Conclusions ................................................................................................................... 122

6.1 Introduction.......................................................................................................................... 122 6.2 Conclusions about the research questions............................................................................ 124

6.2.1 Overall performance of domestic equity funds ............................................................ 124 6.2.2 Performance of bank and non-bank domestic equity funds.......................................... 125 6.2.3 Factors affecting performance of domestic equity funds.............................................. 126 6.2.4 Factors differentiating bank and non-bank fund performance...................................... 127

6.3 Conclusions about the research problem ............................................................................. 128 6.4 Implications for finance theory............................................................................................131

6.4.1 Performance of domestic equity funds ......................................................................... 131 6.4.2 Performance comparison of bank and non-bank funds ................................................ 132 6.4.3 Expense ratio, size and fund performance.................................................................... 133 6.4.4 Comparison of bank and non-bank fund characteristics............................................... 134

6.5 Implications for policy and practice..................................................................................... 135 6.5.1 Implications for financial institutions........................................................................... 135 6.5.2 Implications for individual investors ............................................................................ 136 6.5.3 Implications for government policies ........................................................................... 137

6.6 Research limitations............................................................................................................. 137 6.7 Implications for further research..........................................................................................138 6.8 Implications for research methodology................................................................................ 138

References ...................................................................................................................................... 140 Appendices..................................................................................................................................... 146 Appendix A Data, computation and regression outputs................................................................. 147 Appendix B Conference paper 1: Sustainable bank-managed mutual funds ................................. 194 Appendix C Conference paper 2: Performance of approved equity funds..................................... 207 Appendix D Journal article 1: Effects of expenditures and size on mutual fund performance ...... 222 Appendix E Journal article 2: Bank fund management challenges and opportunities ................... 233

x

List of tables

Table 1.1 Summary of model validation techniques........................................................................ 10 Table 1.2 Thesis chapter outline ...................................................................................................... 14 Table 2.1 Growth of Singapore's unit trust industry ........................................................................ 19 Table 2.2 Contribution of various types of unit trusts...................................................................... 20 Table 2.3 Holding period returns of unit trusts in Singapore from 1976 to 1994 ............................ 28 Table 2.4 Distribution of profit and loss for CPF investors ............................................................. 31 Table 3.1 Selection of mutual fund performance determinants ....................................................... 59 Table 3.2 Measurement of fund characteristics................................................................................ 60 Table 3.3 Research issues and hypothesis........................................................................................ 68 Table 4.1 Summary of plausible approaches for financial research................................................. 79 Table 4.2 Research sample............................................................................................................... 84 Table 5.1 Characteristics of domestic equity funds from banks and non-banks .............................. 97 Table 5.2 Fund performance rankings for 1999-2002 and 2003-2004............................................. 98 Table 5.3 Fund beta rankings for 1999-2002 and 2003-2004 ........................................................ 101 Table 5.4 Fund expense ratio rankings for 1999-2002 and 2003-2004.......................................... 102 Table 5.5 Fund size rankings for 1999-2002 and 2003-2004......................................................... 103 Table 5.6 Regression of equity fund and market index risk premiums.......................................... 106 Table 5.7 Information ratios for domestic equity funds................................................................. 107 Table 5.8 Sharpe and Treynor ratios for domestic equity funds .................................................... 109 Table 5.9 Performance measures of bank and non-bank domestic equity funds ........................... 110 Table 5.10 Two-sample t-test for bank and non-bank fund returns ............................................... 111 Table 5.11 Two-sample t-test for information ratios of bank and non-bank funds........................ 112 Table 5.12 Two-sample t-test for Jensen alphas of bank and non-bank funds............................... 113 Table 5.13 Two-sample t-test for Sharpe ratios of bank and non-bank funds................................ 114 Table 5.14 Two-sample t-test for Treynor ratios of bank and non-bank funds.............................. 114 Table 5.15 Two-sample t-test for returns of big and small funds .................................................. 115 Table 5.16 Two-sample t-test for returns of high and low expense ratio funds ............................. 116 Table 5.17 Two-sample t-test for expense ratios of big and small funds....................................... 117 Table 5.18 Two-sample t-test for size of bank and non-bank funds .............................................. 118 Table 5.19 Two-sample t-test for beta of bank and non-bank funds.............................................. 119 Table 5.20 Two-sample t-test for expense ratio of bank and non-bank funds ............................... 120 Table 5.21 Results of hypothesis testing........................................................................................ 121 Table 6.1 Performance comparison of bank and non-bank domestic equity funds........................ 126 Table 6.2 Relation between fund expense ratio, size and performance ......................................... 127 Table 6.3 Comparison of bank and non-bank fund characteristics ................................................ 128 Table 6.4 Literature contribution on fund performance ................................................................. 132 Table 6.5 Literature contribution on performance of bank and non-bank funds............................ 133 Table 6.6 Literature contribution on fund characteristics and performance................................... 134

xi

List of figures

Figure 1.1 Overview map................................................................................................................... 2 Figure 2.1 Background map ............................................................................................................. 16 Figure 2.2 Singapore's geographical location...................................................................................18 Figure 2.3 Growth of CPF-approved and non-CPF-approved unit trusts ........................................ 21 Figure 2.4 Risk classification of CPF-approved unit trusts.............................................................. 22 Figure 3.1 Literature map................................................................................................................. 36 Figure 3.2 Weak, semi-strong and strong forms of market efficiency............................................. 38 Figure 3.3 Derivation of research issue 1 on unit trust performance ............................................... 40 Figure 3.4 Derivation of research issue 2 on relative performance of FMCs .................................. 45 Figure 3.5 Derivation of research issue 3 on mutual fund performance determinants..................... 48 Figure 3.6 Derivation of research issue 4 on bank and non-bank fund characteristics .................... 58 Figure 3.7 Conceptual model of mutual fund performance ............................................................. 61 Figure 4.1 Methodology map ........................................................................................................... 70 Figure 4.2 Fund performance model with variables and hypotheses labelled.................................. 85 Figure 4.3 Framework for assessing statistical studies .................................................................... 88 Figure 5.1 Data analysis map ........................................................................................................... 96 Figure 5.2 Daily Straits Times Index from 1987 to 2005 ................................................................ 99 Figure 5.3 Quarterly STI returns from 1988 to 2004 ..................................................................... 100 Figure 5.4 Time series regression of a domestic equity fund......................................................... 104 Figure 5.5 Normal probability plot of a domestic equity fund....................................................... 105 Figure 6.1 Conclusions map........................................................................................................... 123 Figure 6.2 Conceptual model of mutual fund performance determinants...................................... 129

xii

List of equations

Equation 2.1 Calculation of breakeven return for a mutual fund ..................................................... 24 Equation 3.1 Information ratio for Singapores domestic equity funds ........................................... 41 Equation 3.2 Jensen alpha for Singapores domestic equity funds .................................................. 42 Equation 3.3 Sharpe ratio for Singapores domestic equity funds ................................................... 42 Equation 3.4 Treynor ratio for Singapores domestic equity funds ................................................. 43 Equation 3.5 Single-index model for domestic equity fund returns................................................. 62 Equation 4.1 Linear regression model for domestic equity fund returns ......................................... 86 Equation 4.2 t-statistic for comparing a characteristic for two groups of funds .............................. 87

xiii

Abbreviations

AIMR Association for Investment Management and Research

APT Arbitrage pricing theory

CAPM Capital asset pricing model

CML Capital market line

CPF Central Provident Fund

DBS Development Bank of Singapore

DJIA Dow Jones Industrial Average

EMH Efficient market hypothesis

EDB Economic Development Board

ETF Exchange-traded fund

FMC Fund management company

FTA Free Trade Agreement

HPR Holding period return

ICI Investment Company Institute

ILP Investment-linked insurance product

IMAS Investment Management Association of Singapore

MAS Monetary Authority of Singapore

MOM Ministry of Manpower

MSCI Morgan Stanley Capital International

NAV Net asset value

NYSE New York Stock Exchange

OCBC Overseas Chinese Banking Corporation

OUB Overseas Union Bank

P/B Price-to-book

P/E Price-to-earnings

S&P Standard and Poors

SML Security market line

STI Straits Times index

UOB United Overseas Bank

USA United States of America

xiv

Glossary

Balanced fund: Mutual fund investing in a combination of bonds and stocks.

Bond fund: Mutual fund investing mainly in government and corporate bonds.

Equity fund: Mutual fund investing generally in common stocks.

Financial institution: Intermediaries (such as banks, insurance companies and mutual

funds) that borrow funds from lenders and make loans to borrowers.

Index fund: Passively managed mutual fund designed to mimic an index of securities.

Investment company: Corporation, trust or partnership investing pooled shareholder

dollars in securities appropriate to the organizations objective.

Money market fund: Mutual fund investing in high-quality short-term securities

Mutual fund: Investment company purchasing a portfolio of securities chosen by a

professional investment adviser to meet a specific financial goal for investors buying

shares from the company.

Net asset value (NAV): Total market value of assets divided by number of shares

outstanding.

Risk: Uncertainty associated with an assets return.

Unit investment trust: Investment company buying and holding fixed number of shares

until a termination date.

Unit trust: Financial institution (similar to mutual fund) inviting the public to subscribe in

funds invested by the company in assets specified by its trust deed.

1

Chapter 1 Research overview

1.1 Introduction

This study concerns an area of interest to investment analysts and fund managersfactors

influencing mutual fund performance differences, based on type of financial institution

managing the fund. The purpose of this study is to examine relationships between unit trust

performance and these factors in Singapores fund management industry: (1) risk, (2)

transaction costs, (3) fund size and (4) type of fund management company.

Objectives for conducting this research are to:

1. clarify conflicting results from existing literature comparing performance of funds

managed by different types of financial institutions;

2. determine whether factors influencing performance of funds managed by banks differ

from their non-bank counterparts; and

3. establish a conceptual model relating characteristics of funds to their performance.

Existing literature on performance comparison of mutual funds managed by different types

of financial institutions reported conflicting results. Until the 1990s, finance literature

reported bank-managed funds being inferior to their non-bank counterparts (Bauman &

Miller 1995; Bogle & Twardowski 1980), but a later study showed bank-managed bond

funds were not inferior to their counterparts from other institutions (Frye 2001). However,

Frye did not research how equity funds managed by these institution groups compare.

Literature on fund performance differences focused on fund manager characteristics,

including age, education (Chevalier & Ellison 1999) and gender (Atkinson, Baird & Frye

2003). This research proposes an empirical study of how factors influencing fund

performance differ with type of fund management institutionbanks as well as insurance

and investment companies. Studying historical performance of unit trusts invested using

Chapter 1

2

Singapores Central Provident Fund (CPF) reveals effects of such factors on funds

managed by banks and non-banks.1

This chapter provides a preview of research documented in this thesis on an empirical

study of factors influencing unit trust performance in Singapore. Figure 1.1 below

presents a map outlining this overview.

Figure 1.1 Overview map

Source: developed for this research.

In this chapter, following section 1.2s background information on nature of mutual funds

and challenges facing them, section 1.3 presents research problem and questions

concerning fund performance comparison and determination of factors affecting fund

performance, before section 1.4 complements these questions with definitions of terms

applied in this research. Section 1.5 justifies methodology used while assumptions and

delimitations placed on this research are explained in section 1.6. This is followed by

section 1.7s outline of thesis chapters before section 1.8 concludes the chapter.

1 CPF is a public defined-contribution pension plan for employees in Singapore, who decide how their CPF accounts are invested in CPF-approved securities, as explained in the following chapter on research background.

1 Research overview

1.1 Introduction

1.2 Background to the research 1.2.1 Nature of mutual funds1.2.2 Challenges facing mutual funds

1.3 Research problem and questions

1.4 Definitions

1.5 Methodology1.5.1 Data collection1.5.2 Statistical analysis1.5.3 Model validation

1.6 Assumptions and delimitations 1.6.1 Assumptions1.6.2 Delimitations

1.7 Thesis plan

1.8 Conclusion

Research overview

3

The next section presents background information on mutual funds in a global context.

1.2 Background to the research

Information concerning nature and management of mutual funds are presented before

discussing challenges to mutual funds from alternative investment products.

1.2.1 Nature of mutual funds

A mutual fund is an investment vehicle that pools capital from clients purchasing its shares

to invest in a portfolio of securities, with purchasing and selling of securities being decided

by a fund manager (Reilly & Brown 2003, p. G11). Three parties are involved in a mutual

fund: board of directors, a fund management company (FMC) and shareholders.

Independent from the FMC, the board of directors is responsible for safeguarding interests

of client shareholders by ensuring the FMC complies with contractual regulations

regarding duties and compensation. Duties of an FMC include investment research,

portfolio management and issuing dividends. As for compensation, management fee is

stated as a percentage of total fund value. Shareholders are investors seeking dividend

income and capital gains from shares of the fund.2 By purchasing new issues of shares at

launch price or secondary issues at asking price and subsequently selling at a higher price,

shareholders can earn a capital gain. Alternatively, shareholders may incur capital loss

with selling price lower than purchase price (Koh 1999).

The FMC appoints a fund manager to generate returns for shareholders while satisfying the

funds investment objectives. To achieve economies of scale and appeal to investors with

different risk-return preferences, each FMC manages a family of funds with different

characteristics, promoting flexibility by letting shareholders switch funds in response to

2 Specifically, investors return for fund f RETf = (EPf BPf + DIVf) / BPf where BPf, EPf and DIVf are the beginning price, ending price and dividend paid for fund f during the investment horizon.

Chapter 1

4

different financial conditions (Reilly & Brown 2003, p. 1074). However, mutual funds

face competition from alternative investment products.

1.2.2 Challenges facing mutual funds

Mutual funds face competition from various alternatives, as fund performance was

generally not impressive. Studies done by Jensen (1968), Malkiel (1995) and Sharpe

(1966) reported most funds did not match performance of comparable market indexes.

According to these studies, slightly more than 50 percent of mutual funds outperformed

their targeted markets before considering transaction costs. After considering such costs,

more than 60 percent of funds did not match their market performance, with the remainder

performing inconsistently. Transaction costs are therefore considered in Chapter 3s

theoretical framework for fund performance determinants.

Unimpressive mutual funds are facing competition from newer alternatives, including

exchange-traded funds (ETFs), folios and separately managed accounts. These alternatives

offer certain advantages over mutual funds. For example, ETFs combine features of index

funds with low expenses for trading stocks; folios let investors customize diversified stock

portfolios; while separately managed accounts give investors access to professional

managers who choose stocks for multiple accounts to achieve diversification (Jones 2003,

pp. 144-5).

Mutual fund information presented in this section is generally applicable to developed

financial markets around the world. The following section presents research problem and

questions while the next chapter presents additional information in Singapores context.

This research derives from the mutual fund performance parent discipline and contributes

to the immediate discipline of fund performance determinants, which are reviewed in

Chapter 3.

Research overview

5

1.3 Research problem and questions

Background information from the previous section introduces the research problem:

Factors influencing mutual fund performance differences, based on type of financial

institution managing the funds.

Factors differentiating performance of funds can be their observable characteristics, among

them size, risk and transaction costs, while financial institutions managing funds are

classified as banks and non-banks. This research problem leads to questions concerning

fund performance comparisons and determination of factors differentiating fund

performance.

Research question 1: How do Singapores unit trusts vary in terms of performance?

Comparing capital markets in Europe and the United States of America (USA) with those

in the Asia Pacific region, as Asia Pacific markets were less efficient with more profitable

opportunities, a higher proportion of funds in Singapore can outperform their relevant

indexes, compared to more developed European and USA markets (Wong 2004). Unit

trusts approved for the CPF Investment Scheme are examined. CPF account holders who

choose not to participate in the scheme earn guaranteed minimum interest rates of 2.5 and

4.0 percent for Ordinary and Special accounts respectively (CPF Investment Scheme

2005).3 Rational CPF members may leave their contributions in these accounts to earn

guaranteed interest rates if returns from CPF-approved unit trusts cannot outperform

guaranteed interest rates. Information gathered from government surveys and press

releases provide some answers to this question in the next chapter.

Research question 2: How does performance of funds managed by banks compare with

their non-bank counterparts?

3 Information about CPF Ordinary and Special accounts are presented in the next chapter.

Chapter 1

6

Frye (2001) reported bank-managed bond funds were not inferior to their counterparts

from other institutions facing similar fiduciary standards, but she did not research how

equity funds managed by these institutions compare. Examining CPF-approved funds

provides performance comparison of equity funds managed by various institution groups

following similar fiduciary responsibilities. Chapter 3s literature review presents

conflicting results from studies on performance of funds managed by different types of

financial institutions.

Research question 3: What are important characteristics of funds affecting their

performance?

Asset allocation, expenses, risk and size are some important characteristics of funds

affecting their performance (Peterson et al. 2002), as funds positive excess returns are

intuitively associated with low-cost investments in equities with high level of systematic

risk. To confirm these factors, a mutual fund performance model is developed in Chapter

3s theoretical framework.

Research question 4: How do differences in fund characteristics account for performance

differences among funds managed by various types of financial institutions?

As portfolio managers in banks had a reputation for risk-averse investment strategies

(McTague 1994), their conservative investment style may incur less transaction costs than

their non-bank counterparts. Besides, bank funds inferior performance (Bauman & Miller

1995; Bogle & Twardowski 1980) may result in less popular and smaller funds than their

non-bank counterparts. Chapter 3 develops a mutual fund performance model to

differentiate characteristics affecting fund performance for various institution groups.

To clarify terms used in research questions as well as remaining chapters, the following

section explains key terms used for this research.

Research overview

7

1.4 Definitions

As this thesis uses various financial terms whose definitions are often not uniform among

researchers, key and controversial terms are defined in this section to clarify research:

balanced fund, bond fund, equity fund, financial institution, index fund, investment

company, money market fund, mutual fund, net asset value (NAV), risk, unit investment

trust and unit trust.4

In any countrys financial system, there are various types of financial institutions,

including banks as well as insurance and investment companies, which borrow funds from

lenders and make loans to borrowers (Mishkin & Eakins 2003, p. 8). According to the

Investment Company Institute (ICI), the national association of investment companies in

the USA, an investment company is a corporation, trust or partnership that invests pooled

shareholder dollars in securities appropriate to the organizations objective (ICI 2004).

Among investment companies, mutual funds purchase portfolios of securities chosen by

professional investment advisers to meet specific financial goals for investors buying

shares from these companies (ICI 2004). In Australia and Singapore, instead of mutual

fund, the alternative name unit trust is used.5 Unit trusts are financial institutions that

invite the public to subscribe in funds invested by the company in assets specified by its

trust deed (McGrath & Viney 1998, p. 29). Unit trusts in Singapore should not be confused

with unit investment trusts in the USA, which are investment companies that buy and hold

fixed number of shares until a termination date (ICI 2004).

This thesis uses the terms unit trusts and mutual funds synonymously to refer to funds

which are managed by banks as well as insurance and investment firms. Common types of

funds managed by these institutions include bond funds that invest generally in long-term

4 The Glossary on page xiv provides complete listing of definitions. 5 Even though unit trusts are operationally similar to mutual funds, they are legally different, as explained in the following chapter.

Chapter 1

8

government and corporate bonds, equity funds investing generally in common stocks,

balanced funds investing in a combination of bonds and stocks, index funds investing in

securities that make up a market index and money market funds that invest in short-term

securities (Reilly & Brown 2003, pp. 86-7). Such funds are risky assets as they have

uncertain future returns. A funds market value can be measured by computing its per-

share value, or NAV, which is calculated by dividing total market value of assets in the

fund by its number of shares outstanding (Reilly & Brown 2003, p. 1074).

1.5 Methodology

Following clarification of financial terms, this section outlines procedures for secondary

data collection, data analysis and model validation. These procedures and their results are

elaborated in Chapters 4 and 5 respectively.

1.5.1 Data collection

For data collection, quarterly returns, fund sizes and expense ratios for CPF-approved

domestic equity funds managed by banks, insurance companies and investment firms, as

well as levels of the local stock market Straits Times index (STI) from 1999 to 2004 were

downloaded from the CPF Board and Yahoo Finance websites to perform a five-year

quantitative analysis.6

From 1999 to 2004, quarterly data were recorded for the following variables:

1. EXP: expense ratio recorded as a percentage;

2. FMC: type of financial institution managing the fund (bank or non-bank);

3. RET: unit trusts percentage rate of return;

6 Data for CPF-approved unit trusts were taken from quarterly Performance and Risk Monitoring Reports downloaded from the CPF Board web site at http://www.cpf.gov.sg. Reports are available from 1999 after liberalization of CPF rules governing unit trust investments. The Yahoo Finance website is http://finance.yahoo.com.

Research overview

9

4. RFR: risk-free percentage rate of return, corresponding to prevailing guaranteed

interest rate earned by CPF accounts;

5. RSK: risk classification reflecting funds equity and focus risks (see section 2.2.5 for

details);

6. STI: STIs percentage rate of return; and

7. SZE: funds net assets under management, measured in Singapore dollars.

Data collected were used for statistical analysis conducted for this research.

1.5.2 Statistical analysis

Secondary financial data analysis involved preliminary classification of funds according to

FMC and RSK variables. For each fund, regression analysis of its returns on market returns

was carried out based on Sharpes (1964) capital asset pricing model (CAPM) before

performance measures developed by Goodwin (1998), Jensen (1968), Sharpe (1966) and

Treynor (1965) were computed. Hypothesis testing of fund characteristics was mainly

carried out using two-tail pooled-variance t-test for differences in two means.

1.5.3 Model validation

To assess how fitted regression models perform in practice, examining predicted values

can identify an invalid model. For example, unreasonable predicted values indicate an

incorrect form of the model or badly estimated coefficients. Very huge or very small

coefficients with large standard errors or signs opposite of what were expected indicate a

poorly performing model. Also, collecting new data for other periods and splitting existing

data for cross-validation of the fitted models predictive ability help to validate the model

(Mendenhall & Sincich 1996, pp. 489-91). These techniques are listed in Table 1.1 on the

following page.

Chapter 1

10

Table 1.1 Summary of model validation techniques Technique Objective Examination of predicted values

Reveal incorrect form of model or poorly estimated coefficients

Examination of estimated model parameters

Indicate whether model may perform poorly when applied with new data

Prediction using collection of new data

Determine accuracy of prediction to assess how well model performs in practice

Cross validation Estimate model parameters and assess fitted model's predictive ability using different groups of collected data

Source: based on Mendenhall and Sincich (1996, pp. 489-91).

The next section presents key assumptions and delimitations placed on this research.

1.6 Assumptions and delimitations

This section presents theoretical and statistical assumptions, followed by delimitations

imposed by these assumptions.

1.6.1 Assumptions

Several major investment theories underlie this research: Famas (1970) efficient market

theory, Markowitzs (1952) portfolio theory, Ross (1976) arbitrage pricing theory (APT),

and Sharpes (1964) CAPM. After highlighting theoretical assumptions, this subsection

presents statistical assumptions. For theoretical assumptions, efficient market theory is

presented first, followed by asset pricing theories in chronological order.

Efficient market theory

Famas (1970) assumptions for an efficient capital market include:

large number of independent profit-maximizing participants analysing and valuing

securities;

new information on securities arriving at the market in a random and independent

manner; and

profit-maximizing investors adjusting security prices rapidly to reflect effect of new

information.

Research overview

11

These assumptions underlie the efficient market hypothesis (EMH) reviewed in Chapter 3,

which referred to literature supporting the notion of efficiency in Singapores fund market.

Asset pricing theories

Sharpes (1964) CAPM is the basis for risk-adjusted portfolio performance measures from

Goodwin (1998), Jensen (1968), Sharpe (1966) and Treynor (1965) applied in this

research. As CAPM was built on portfolio theory, Markowitzs (1952) assumptions about

investors are presented first:

representing each investment alternative as a probability distribution of expected

returns for a holding period;

maximizing one-period expected utility on utility curves demonstrating diminishing

marginal utility of wealth;

estimating portfolio risk from variability of expected returns;

making investment decisions based on expected return and risk, so that utility curve is

a function of expected return and expected variance of returns; and

preferring higher returns to lower returns for a given risk level and preferring less risk

to more risk for a given level of expected return.

Five additional assumptions imposed by CAPM (Sharpe 1964) on investors are:

1. being efficient by making portfolio selection based on risk-return utility function;

2. borrowing or lending money at risk-free rate of return;

3. having homogeneous expectation for distribution of future returns;

4. having the same time horizon; and

5. buying or selling infinitely divisible assets in capital markets that are in equilibrium,

with no taxes, transaction costs, inflation or change in interest rates.

Imposing these CAPM assumptions does not make the research unrealistic, because

relaxing them does not change the main CAPM implications (Reilly & Brown 2003, p.

Chapter 1

12

239). Besides, this research fulfilled some CAPM assumptions, as guaranteed CPF interest

rates were constant and CPF-approved unit trusts were generally tax-exempted from 1999

to 2004. As an alternative to CAPM, APT (Ross 1976) imposes fewer assumptions:

capital markets being perfectly competitive;

investors preferring more wealth to less wealth; and

stochastic process generating asset returns being expressed as a linear function of a set

of risk factors.

By examining fund characteristics, this research supports APTs notion of various risk

factors affecting returns. Besides, regression analysis is performed for each fund to

compute its required rate of return based on CAPMs risk-return assumptions.

Statistical assumptions

Standard least square assumptions apply for the linear regression model based on CAPM:

1. normal distribution of error terms with zero mean and equal variance; and

2. independent errors associated with any pair of observations (Mendenhall & Sincich

1996, pp. 115-6).

Besides least square assumptions, assumptions for hypothesis testing of difference between

two population means are required:

1. both sampled populations having approximately normal frequency distributions with

equal variances; and

2. random samples being independently selected from their populations (Mendenhall &

Sincich 1996, p. 63).

Violation of statistical assumptions can result in problems identified in the following

subsection.

Research overview

13

1.6.2 Delimitations

By applying a regression model, its assumptions impose delimitations on this research.

Four such problems are explained (Mendenhall & Sincich 1996, pp. 367-8):

1. Establishing cause and effect relationship. Since data used in regression were

uncontrolled rather than experimental, it is inappropriate to deduce cause-and-effect

relationship for fund returns.

2. Departure from assumptions. Violation of regression assumptions specified in the

previous subsection may lead to unreliable results. However, it is unlikely assumptions

for error terms are satisfied exactly. When departures from assumptions are slight, the

model remains valid.

3. Multicollinearity. Variables used in the model may be highly correlated resulting in

erroneous computation of coefficients as well as t tests on coefficients being

insignificant and F test of overall model showing significance. Residual analysis is

applied to resolve this problem in Chapter 5.

4. Extrapolation. It is risky to use the model to predict outside the range of collected data

because unusual changes, whether economic or political, may make the model

inappropriate for such future prediction. As adequacy of model for extrapolation is

unknown, reliability of such inference will be less than the 95 percent level of

confidence applied for this research.

As the research problem focused on explaining factors differentiating fund performance

for various types of institutions, prediction about future returns was not contemplated.

Forecasting without recognizing delimitations results in regression abuse.

Chapter 1

14

1.7 Thesis plan

After stating research assumptions and delimitations, an outline of thesis chapters in Table

1.2 previews contents in each chapter. Chapter 1 introduces purposes, objectives, research

problem and methodology while Chapter 2 provides background information in

Singapores context as well as supporting justification for this research. In Chapter 3, a

literature review identifies major contributions in mutual fund research to develop a

theoretical framework for factors influencing fund performance.

Table 1.2 Thesis chapter outline Chapter Topic Contents

1 Research overview Purposes and objectives Summary of research problem Methodology General background to the research

2 Background and research justification

Demographics of Singapore's fund industry Demographics of mutual fund research in Singapore Importance of the research for Singapore Justification for the research

3 Literature review Identification of key mutual fund researchers and their contributions Theoretical framework

4 Research methodology

Secondary data collection Data analysis approach

5 Data analysis Analysis of secondary financial data

6 Conclusions Summary of findings Interpretation of analysis Implication of the research Plausible future research

Source: adapted from Meredith (n.d, p. 2).

Research methodology is presented in Chapter 4, covering secondary data collection,

regression analysis and hypothesis testing for producing findings reported in Chapter 5.

Chapter 6 concludes with interpretation of Chapter 5s analysis to suggest implications as

well as future research opportunities.

1.8 Conclusion

This overview presented a linear regression approach to modelling performance of unit

trusts observed for Singapores CPF Investment Scheme. Even though ETFs, folios and

Research overview

15

separately managed accounts offer various advantages, mutual funds remain relevant as

they facilitate ownership of diversified securities by individual investors and occupy a

significant share of retirement plan assets. The following chapter provides information in

Singapores context while Chapter 3 reviews literature to identify factors influencing fund

performance.

This research on characteristics of mutual funds affecting their performance differences

based on type of FMC is important as it can contribute to finance knowledge and fill a

perceived gap in the literature on performance of equity funds facing similar fiduciary

standards. Most importantly, this research benefits the mutual fund industry by revealing

factors differentiating performance of funds managed by various institution groups. These

groups can build on identified factors to produce better performing funds that can compete

more effectively with alternative products for investors money. Further research

justification is presented in the next chapter.

16

Chapter 2 Background and research justification

2.1 Introduction

Chapter 1 introduced the research problem: determining factors influencing fund

performance differences based on type of institution managing the fund, and associated

questions: (1) how Singapores unit trust performance vary; (2) how performance of funds

managed by banks compare with non-bank funds; (3) which fund characteristics determine

performance and (4) how differences in characteristics account for performance

differences among funds managed by various institution types. In this chapter, background

information and research justification are presented in Singapores context. Background

information sets the scene for research while justification is targeted mainly at Singapore.

A background map outlining sections in this chapter is set out in Figure 2.1.

Figure 2.1 Background map

2 Background andresearch justification

2.1 Introduction

2.2 Background tothe research problem

2.2.1 Singapore's demographic characteristics2.2.2 Demography of Singapore's asset management industry2.2.3 Equity, bond, balanced and money market funds2.2.4 CPF-approved and non-CPF-approved unit trusts2.2.5 Risk classification of unit trusts2.2.6 Fee structure of unit trusts2.2.7 Regulation of unit trusts

2.3 Performance ofunit trusts in Singapore

2.4 Contribution ofthe research

2.5 Justification forthe research

2.5.1 Gaps in the mutual fund literature2.5.2 Research approach2.5.3 Benefits for Singapore's unit trust industry

2.6 Conclusion

2.3.1 Fund performance from 1976 to 19942.3.2 Fund performance from 1999 to 20032.3.3 Performance of CPF-approved unit trust investors

2.4.1 Mutual fund multifactor model2.4.2 Conference presentations and article publications2.4.3 Research outcomes for finance teachers and researchers

Source: developed for this research.

Background and research justification

17

In section 2.2, after a summary of Singapores demographic characteristics, background

information on Singapores unit trust industry is presented using secondary data from press

releases and government surveys. Such data provide some answers to the first research

question in section 2.3, while research contribution and justification are presented in

sections 2.4 and 2.5 respectively in the context of a deregulating asset management

industry facing increasing competition, before section 2.6 concludes this chapter.

2.2 Background to the research problem

Unit trust is a popular form of investment in Singapore, as for mutual funds in the USA.

Singapores unit trust industry can be divided into two segments: retail and wholesale

segments accepting investments from individuals and institutions respectively.

This study focused on CPF-approved unit trusts after liberalization of the CPF Investment

Scheme in 1999, which belongs to the retail segment. Majority of findings in this section

were derived from information released by the Monetary Authority of Singapore (MAS),

Singapores central bank.1

2.2.1 Singapores demographic characteristics

Among the smallest countries in the world, Singapore is an equatorial island located at the

southern tip of the Malaysia peninsula in Southeast Asia, as shown in Figure 2.2 on the

next page.

According to Singapores Economic Development Board (EDB), the country houses more

than four million people with a majority of Chinese, Malays and Indians in that order.

While English is the language of administration, Chinese, Malay and Tamil are commonly

used (EDB 2004).

1 Financial institutions surveyed by MAS included investment advisers, fund managers, finance and treasury centres, operational headquarters and banks; while total assets under management included unit trusts, funds under advisory service, funds contracted by financial institutions in Singapore as well as funds from individual and institutional clients (MAS 1998-2004).

Chapter 2

18

Figure 2.2 Singapore's geographical location

Location: Southern tip of Malaysia Peninsula, Southeast AsiaLand area: 685.4 km sq

Source: statistics from EDB (2004).

On the economic front, the countrys money supply and foreign reserves totalled about

S$37 billion and S$143 billion respectively in 2002. For that year, with S$208 billion of

imports and exports reaching S$224 billion, total trade amounted to S$432 billion.

Supporting the countrys economy is a labour force of about two million, with

unemployment rate less than five percent. As a financial hub in the Asia Pacific region, the

country hosts five local banks and more than 100 foreign banks participating in its asset

management industry (EDB 2004).

2.2.2 Demography of Singapores asset management industry

Singapores asset management industry reported close to S$465 billion of total assets

managed by financial institutions at the end of 2003, an increase of more than S$30 billion

per year since 2000, charting more than 11 percent of annual growth, as shown in Table

2.1 on the next page. Among asset types under management, unit trusts represented S$14

billion or 4 percent of total assets in 2003. Funds invested in unit trusts grew close to 500

percent from 1997 to 2003, representing $16 billion of increase from S$3 billion at the end

of 1997. Except for 1998, which suffered a slight dip in asset value due to the Asian

Background and research justification

19

financial crisis, unit trusts assets under management grew in excess of 15 percent each

year, with highest growth registered in 1999, coinciding with recovery of Asian financial

markets as well as liberalization of the CPF Investment Scheme (MAS 1998-2004).

Table 2.1 Growth of Singapore's unit trust industry Year No. of FMCs No. of

funds Net assets of funds Total assets under

management (S$ bil) Proportion of total

assets (%) (S$ bil)

1997 22 101 3.3 2.7 124.1 1998 23 127 3.2 2.1 150.6 1999 25 187 6.8 2.5 273.7 2000 31 265 7.8 2.8 276.2 2001 32 319 10.5 3.4 307.0 2002 32 382 14.1 4.1 343.8 2003 34 401 19.2 4.1 465.2

Source: derived from MAS (1998-2004).

Accompanying growth in net assets was an increase in number of FMCs and their funds.

As shown in the table above, from 22 companies managing 101 funds in 1997 to 34

managing 401 funds in 2003, the industry witnessed introduction of about 50 new funds

per year, with number of companies stabilizing around 30 since 2000.

To organize information on Singapores unit trust industry for further analysis, FMCs are

classified into banks and non-banks, with non-banks comprising insurance and investment

companies. Besides, unit trusts are classified in the next three subsections according to

type of securities held, whether they are CPF-approved as well as risk characteristics.

2.2.3 Equity, bond, balanced and money market funds

Actively managed unit trusts can be classified into four basic types: (1) equity funds, (2)

bond funds, (3) balanced funds and (4) money market funds, as explained in section 1.4.

Besides showing contribution to net assets from these fund types, Table 2.2 on the

following page introduces capital-protected fundsbond funds that guarantee investors

their capital and a percentage of profits after staying invested for a number of years.

Chapter 2

20

Table 2.2 Contribution of various types of unit trusts 1999 2000 2001 2002 2003 Type of

fund Qty Net assets (S$ mil)

Qty Net assets (S$ mil)

Qty Net assets (S$ mil)

Qty Net assets (S$ mil)

Qty Net assets (S$ mil)

Equity 134 5,658 189 6,226 206 6,200 203 5,642 186 6,994 Bond 24 651 26 709 32 1,133 36 1,389 46 2,415 Balanced 17 410 28 568 27 986 36 1,112 36 1,521 Money market

11 44 12 87 15 423 16 570 10 541

Capital guaranteed

1 38 10 253 39 1,782 82 5,423 119 7,635

Others 0 0 0 0 0 0 9 11 4 88 Total 187 6,801 265 7,843 319 10,524 382 14,147 401 19,195 Source: derived from MAS (1998-2004).

Proportion of equity funds accounted for more than 70 percent of funds in 1999 and still

accounted for about 40 percent in 2003. During the same period, proportion of money

invested in bond funds and balanced funds remained relatively constant at about 20

percent; while capital-protected and money market funds grew from a negligible

proportion in 1999 to almost 40 percent in 2003 at the expense of equity funds, which

experienced a bearish global stock market during that period.

ETFs, hedge funds invested in derivatives, as well as real estate investment trusts invested

in buildings, represented a very small portion of total funds. For this research, only equity

funds invested in the local stock market were considered. Other funds based on non-STI

benchmarks were excluded as benchmarks have unique market cycles. The STI,

Singapores principal stock market index, is an unweighted index of about 30 stock issues

(Ibbotson & Brinson 1993). To fulfil the common fiduciary standard criteria, the research

approach, elaborated in section 2.5.2, excluded non-CPF approved unit trusts, which are a

minority. Specifically, data are collected and analysed for CPF-approved domestic equity

unit trusts.

Background and research justification

21

2.2.4 CPF-approved and non-CPF-approved unit trusts

In 1999, the CPF Board engaged an independent firm, Mercer Investment Consulting, to

advise whether proposed unit trusts were suitable for investment of retirement savings.

Unit trusts considered suitable are CPF-approved. Before 2000, CPF-approved unit trusts

were less popular than their non-CPF approved counterparts. As shown in Figure 2.3

below, number of CPF-approved funds and their assets under management were both less

than their non-CPF-approved counterparts before 2000.

Figure 2.3 Growth of CPF-approved and non-CPF-approved unit trusts

Source: derived from MAS (1998-2004).

Since 2000, CPF-approved funds outgrew their non-CPF-approved counterparts. From

2000, net assets managed by CPF-approved funds exceeded their non-CPF-approved

counterparts, while number of CPF-approved funds became more than non-CPF-approved

ones by 2002. By 2003, CPF-approved funds represented more than 70 percent of assets

under management in Singapores unit trust industry.

Suitability assessment of CPF-approved unit trusts is probably conducted using imperfect

informationperformance history and limited knowledge of FMCs. This measurement

0

50

100

150

200

250

300

350

400

450

1997 1998 1999 2000 2001 2002 2003

Y ear

(a) Number of funds

CPF-approved Not CPF-approved

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

20,000

1997 1998 1999 2000 2001 2002 2003

Year

(b) Net assets (S$ million)

CPF-approved Not CPF-approved

Chapter 2

22

problem results in information asymmetry, which is reduced by regulation, contracting,

monitoring and security design (Sawicki & Thomson 2000). Mercer is an example of

private agency contracted by government to monitor offering of CPF-approved unit trusts

meeting investment guidelines pertaining to disclosure of information on investments and

prevention of excessive investment in few companies or very risky assets.

2.2.5 Risk classification of unit trusts

Besides approving unit trusts for CPF investments, Mercer developed a risk classification

system to group them according to risk-return characteristics, which assists CPF members

when choosing funds to meet their needs and investment objectives (CPF Investment

Scheme Risk Classification System 2004). This system, shown in Figure 2.4, represented

investment risk using two dimensions: equity risk for exposure to stocks and focus

risk reflecting diversification in various markets.

Figure 2.4 Risk classification of CPF-approved unit trusts

Source: derived from CPF Investment Scheme Risk Classification System (2004).

Equity risk dimension was divided into four categories: (1) lower risk, (2) low to medium

risk, (3) medium to high risk and (4) higher risk, corresponding to money market funds,

bond funds, balanced funds and equity funds respectively.

Focus risk dimension was divided into two categories: (1) broadly diversified for low-

risk unit trusts investing in many geographical regions, countries as well as industries; and

Equity risk Regional Sector CountryHigher risk (equity fund)

Medium to high risk (balanced fund)Low to medium risk (bond fund)Lower risk (money market fund)

Low risk High risk

Focus riskBroadly

diversifiedNarrowly focused

Domestic equity funds

Background and research justification

23

(2) narrowly focused for high-risk funds investing in particular geographical regions,

countries or industries. Within the narrowly focused category were three sub-categories

arranged with increasing level of risk: (1) regional funds investing in emerging markets or

particular continents, (2) sector funds investing in particular industries and (3) country

funds investing in particular countries.

Examining distribution of funds using this classification reveals various risk alternatives

being represented by CPF-approved funds. There are regional funds invested in Asia,

Europe and North America as well as emerging markets. Sector funds are invested in

various industries, including biotechnology, finance, healthcare, information technology

and small-capitalization companies. As for country funds, China, Japan, Singapore, the

United Kingdom and others are included. Non-existence of funds in lower equity risk,

narrowly focused categories is expected, as it is practically impossible to offer very low-

risk regional, country or sector funds.

Even though this system simplifies a full range of risk possibilities, it fulfils its objectives

by assisting investors to visualize risk dimensions. However, investors need to supplement

fund classification with insight from quantifying risk-return characteristics and factors

differentiating performance, which are discussed in this research. Specifically, to answer

the first research question, fund performance is compared with STI index returns and CPF

interest rates. The second research question requires analysis of risk and return

characteristics to determine relative performance of funds managed by different institution

types, while factors differentiating performance among bank and non-bank funds are

identified and tested for research questions 3 and 4 respectively.

For this research, as only CPF-approved domestic equity funds are considered, the

research sample is classified as high-risk narrowly focused country funds, as illustrated

in Figure 2.4 on the previous page. After 2002, Mercer ceased to report performance of

Chapter 2

24

CPF-approved funds and was replaced by Standard and Poors (S&P) Fund Services Asia.

Before gathering some answers for the first research question in section 2.3, remaining

subsections provide information about fee structure and unit trust regulations.

2.2.6 Fee structure of unit trusts

Various charges are associated with unit trust investments. Besides an initial minimum

investment of S$1,000 or S$5,000, a front-end fee is payable to offset marketing cost. No-

load funds have no front-end fees, but most funds have front-end fees ranging from one to

five percent of NAV. After a fund purchase, management fee paid to the FMC ranges from

0.5 to 3 percent of NAV per annum. To sell a unit trust, the investor pays redemption fee

ranging from one to five percent of bid price, or an exchange fee about one percent of

asking price for switching to another fund managed by the same FMC (Koh & Fong 2003).

Ignoring management fees and CPF interest rates, a simplified breakeven rate of return

calculation, given front-end and redemption fees, is illustrated below:

Equation 2.1 Calculation of breakeven return for a mutual fund

1 + FEf = (1 + BEf) (1 RDf) or 111

+=

f

ff RD

FEBE

where BEf FEf RDf

= breakeven rate of return for fund f; = percentage cost in front-end fee for fund f; and = percentage cost in redemption fee for fund f.

Source: derived from Koh and Fong (2003)

Performing a scenario analysis, with the best-case no-load fund with FE = 0% and RD =

1%, lowest breakeven rate of return BEmin = 1 / (1 0.01) 1 or 1 percent approximately.

For the worst-case load fund with FE = 5% and RD = 5%, highest breakeven return BEmax

= (1 + 0.05) / (1 0.05) 1 or around 10.5 percent. With management fee included,

breakeven return is more than the calculated range of 1 to 10.5 percent. No research

supported getting better returns by investing in load funds with higher fees. In fact,

Background and research justification

25

efficient markets literature reviewed in the next chapter confirmed load funds under-

performing an efficient market, lending support for passive investment strategies using

ETFs and index funds to mimic equity indexes.

As expensive fees reduce fund returns, cost reduction is necessary to improve profitability.

Competition within the industry and from alternative products (ETFs, folios and separately

managed accounts) lead to reduced costs. Direct modes of marketing with electronic

commerce further reduce broker commissions. Unit trust legislation can lower costs too.

2.2.7 Regulation of unit trusts

Unit trust legislation protects investors. In Singapore, unit trusts are established by trust

deeds under Section 114 of the Companies Act (Chapter 50), spelling out investment

objectives, methods for calculating NAVs and prices, responsibilities of FMCs and trustees

as well as shareholder rights. Even though unit trusts are operationally similar to mutual

funds, they are legally different as mutual funds are investment companies while unit trusts

are created through trust deeds (Koh & Fong 2003).

Since liberalization of the CPF Investment Scheme, surge in demand for unit trusts is due

to more accommodating regulations and investors increased knowledge of such

investment vehicles (Koh 1999). According to Singapores Ministry of Manpower

(MOM), CPF investments by Singaporeans commenced in 1986 with the Approved

Investment Scheme allowing a portion of CPF to be invested in approved financial

instruments (gold, bonds as well as approved stocks and unit trusts) to groom retirement

income. In 1993, Basic and Enhanced Investment Schemes were introduced, later

integrated to form the CPF Investment Scheme in 1997 (MOM 1998).

In 1998, the CPF Investment Scheme was liberalized to broaden the range of unit trusts

available for investments. Revised investment guidelines gave fund managers more

flexibility in diversifying portfolios for reducing risks, while raising disclosure standards

Chapter 2

26

to inform CPF investors about returns, risks and fund performance comparison. During the

same year, MAS licensed 24 FMCs meeting quality evaluation criteria (Applications for

Admission of Fund Management Companies into CPF Investment Scheme 2001).

Since 2001, Special and Ordinary accounts can fully invest in approved financial

instruments. While Special account is used for old age contingency purposes and

retirement-related financial products, Ordinary account pays for education, housing,

insurance and investments (CPF Handbook: Building Our Future 2005). Among other

changes, the CPF Investment Scheme allowed ETF investments from 2001 (CPF Savings

can now be Invested in Exchange Traded Funds 2001) while unit trusts, investment-linked

insurance products (ILPs), ETFs and fund management accounts denominated in foreign

currencies were permitted in 2002 (Changes to the CPF Investment Scheme 2002).

Unit trust investors use various selection criteria. One criterion is to choose products that

earn higher returns than guaranteed CPF interest rates, which are revised quarterly based

on local bank rates on deposits and savings accounts. However, the CPF Act guarantees a

minimum rate of 2.5 and 4.0 percent for Ordinary and Special accounts respectively (CPF

Handbook: Building Our Future 2005).2 As CPF interest rates are guaranteed if members

choose not to invest in securities, these rates are risk-free and should therefore be based on

the economys real rate of growth, capital market conditions and expected inflation rate

(Reilly & Brown 2003, p. 28). If these factors are not taken into consideration, prevailing

CPF interest rates may be unrealistic. In fact, Douglas (2003) commented 2.5 and 4

percent interest rates on Ordinary and Special accounts from 2002 to 2003 were

unsustainable and hard to outperform on a risk-adjusted basis. However, evaluating unit

trust performance with respect to CPF interest rates may be unfair compared to evaluation

against market indexes.

2 From 2002 to 2004, annual interest rates for CPF Ordinary and Special accounts were 2.5 and 4.0 percent respectively, while bank savings rate was less than 1 percent.

Background and research justification

27

In the following section on fund research in Singapore, evaluation of fund performance

with respect to CPF interest rates and market indexes are considered to provide some

answers to the first research question.

2.3 Performance of unit trusts in Singapore

Evident by literature reviewed in the following chapter, mutual fund performance was

studied extensively in the USA, but little academic research was published on Singapores

unit trusts, other than Koh (1999), Koh and Fong (2003) and Tan (2001). This is due to a

relatively small and young fund management industry that started with less than ten unit

trusts in 1976 (Koh 1999) and grew to a few hundred funds by 2004, compared to

thousands of funds in many developed markets.

Research indicated short-term negative returns and long-term positive returns with

majority of unit trusts under-performing their benchmark indexes and CPF interest rates

before 2000 (Koh 1999). From 2000 to 2002, over 80 percent of CPF-approved unit trusts

turned in negative absolute returns for the three-year period, according to data released by

S&P Fund Services (Ng 2003). Answering partially the first research question on unit trust

performance, research by Koh (1999) and Ng (2003) indicated most unit trusts under-

performing market indexes, implying efficiency in Singapores unit trust industry. As

majority of CPF-approved unit trusts generated negative returns from 2000 to 2002,

earning guaranteed interest rates was a better alternative during that period. Poor equity

fund performance from 2000 to 2002 coincided with bearish equity markets globally.

For this research, examining performance data for a five-year timeframe from 1999 to

2004 spans a business cycle, including strong equity decline during 20002002, a

difficult period for fund managers but appropriate for identifying superior managers and

institution groups. Chapter 5 reconsidered the first research question by analysing data for

the five-year timeframe.

Chapter 2

28

Besides