IT IS often said that the relative inefficiency of Asian equity markets favours active fund management over passive index trackers.

But new research by Vanguard on Asian funds makes a strong case for indexing, using data of up to 10 years to September 2011 from Morningstar. The data covered 2,500 funds whose main regional focus was Asia ex Japan, Greater China, Hong Kong and Singapore.

Zero sum game?

The overall conclusion is bleak for active management, and the numbers look even worse when adjusted for survivorship bias. The latter refers to the failure among most databases to adjust for funds that have closed or dropped out of the universe. Failure to adjust for fund closures tends to overstate average returns.

Vanguard is a US-based group whose founder, John Bogle, is credited with the creation of the first index fund for retail investors. As at end-2011, it managed some US$1.7 trillion of assets, with an average expense ratio of 0.2 per cent.

The challenge for retail investors here is that while there are Asian ETFs listed on the exchange, many are thinly traded. This suggests that the bid/offer spread may be unattractive. There is also little to incentivise advisers to recommend ETFs, which are rarely included in banks' product menus, for instance. As for licensed advisers, most have remuneration structures that are transaction or commission driven, which again make ETFs unattractive compared to active funds where they earn a share of front-end fees and management fees.

Vanguard's research - undertaken by Roger McIntosh, Vanguard's principal of the investment strategy group, and analyst Charles Thomas - posits that investing is a zero-sum game. What this means is that for every winner who outperforms, there will be one who underperforms. Higher costs of active management - including management fees and trading costs - would therefore be an added drag on returns. In theory, if the aggregate returns of active funds are plotted on a bell curve, with the market as the mean or centre line, the curve for active funds would shift towards the left.

This is indeed what the research finds for the funds under study for three, five and 10-year periods. For instance, over three years, 67 per cent of funds underperformed their benchmarks. The number excludes "missing" funds, defined as those that were liquidated or merged in the period. When missing funds were included, the proportion that underperformed was higher at 75 per cent.

The picture is roughly similar for the five-year period, with 75 per cent underperforming when missing funds were included.

Over 10 years, the picture seems to improve somewhat. Excluding missing funds, 50 per cent of active funds underperformed. But when missing funds are included, the figure rose to 67 per cent.

The biggest challenge for retail investors is picking the winner, which may well be a stab in the dark for a number of reasons.

As the study points out, the investor must first be able to choose in advance a manager he believes will have the skill to generate returns greater than fees. Then, the manager must successfully execute on his strategy.

"Although some (market) participants are able to beat the market on occasion, selecting a winning manager who is able to consistently perceive inefficiencies better than the rest of the players is very difficult . . . The incentives for winning are immense, leading to increased competition, which in turn makes alpha that much harder to attain," says the study.

The study finds that the chance of selecting a fund that would remain an ongoing concern and outperform its benchmark over a 10-year period is about one in three or 33 per cent.

Winning funds also appear to be unable to maintain their lead consistently. The study looked at Asian funds over a six-year period to September 2011, divided into two three-year periods against their appropriate benchmarks. The funds were split into quartiles based on the first three-year period.

It found that of the funds ranked in the first quartile in the first three years, 26 per cent were in the first quartile in the second three-year period, which is nearly equal to what chance would suggest. But of the funds that were in the bottom quartile in the first three years, 52 per cent remained there or closed in the second three years, and only 14 per cent migrated to the top quartile.

"This analysis suggests greater persistency on the downside than on the upside."

There was "close to no causal relationship" between a fund's rankings on a month-to-month basis. The authors looked into fund rankings on a year-to-year rolling basis, comparing 12-month rankings in one year to those in the following year. The average correlation over time was 0.12 - "which is close to the value of 0.00 that would be expected if performance persistence were a random walk over time".

As for risk-return profiles over three years to September 2011, only 18 per cent of active funds - roughly one in six - beat the market, as defined by higher returns and lower volatility. In addition, 34 per cent posted lower-than-average returns coupled with higher risk. The authors concede, however, that the time frame of this segment of the study is short and that the results should be interpreted with caution.

Mudit Goenka, senior investment analyst at Providend, says that the firm uses Asian ETFs in client portfolios when it is unable to find managers with a consistent record of outperformance. "In the Asian equity space, we are able to identify certain managers who have delivered consistent outperformance in the past. As such we are comfortable investing in them.

"We do note that it is difficult to spot many such managers and even the ones who have done well in the past might not do so in the future."

He points out that Asian ETFs have generally higher expense ratios of around 70 to 80 basis points compared to US and European ETFs. This generally reduces the attractiveness of Asian ETFs. Many listed on the SGX also suffer from low trading volumes, he says, "making execution a bit difficult".

OCBC Investment Research analyst Lim Siyi says that investors should note that not all ETFs are created equal. "Differences in the replication methodologies used by the ETF manager and expense ratios will result in different returns as well." Swap-based ETFs, he adds, also raise counterparty risks that the investor should be aware of.

On liquidity, he points out that each ETF has a designated market maker to provide liquidity. Some popular listed ETFs such as the SPDR STI ETF, iShares MSCI India ETF and db x-trackers FTSE Vietnam ETF have narrow bid-offer spreads.

The use of ETFs in Singapore is still a relatively new concept among retail investors, he says. "We believe that more education and awareness will certainly help to create an interest in ETFs which will naturally narrow the bid/offer spreads."