Index investing is very popular, especially in Europe and North America but perhaps less so in Asia. The idea behind index investing is simple: because an average investor cannot beat the market consistently over long periods of time, you are best off putting your money in a well-diversified investment fund and spend your time instead on other things, like playing with your kids, improving your golf handicap, updating your social media accounts, running your business, etc.

Research suggests that professional fund managers also don’t beat the index consistently, so you will probably also fail to beat the index if you try to pick the “best” actively managed mutual fund (for background get a hold of Malkiel’s A Random Walk Down Wallstreet and Bogle’s Common Sense on Mutual Funds). Since managed mutual funds tend to have higher charges, that’s another reason to choose an index fund.

But all of this research is typically based on the realities in North America and Europe: large, liquid, (supposedly) well-regulated and sophisticated markets. What about a market like Malaysia’s that’s relatively small and often dominated by large family-owned or government-owned firms. Do index funds beat mutual funds in Malaysia too?

Let’s Hypothesize

Factors that might make Malaysia’s stock market unlike that of North America and Europe is the fact that:

1. Malaysia’s stock market has some regulatory and governance issues (loads of examples here), although these tend to occur with smaller companies that are not included in indexes like the FTSE Bursa Malaysia KL Composite Index ,
2. Malaysia’s economy has some political patronage going on too, as well as large family-controlled businesses through which minority shareholders may get the short end of the stick when they invest in these companies (see also Gomez & Jomo’s Malaysia’s Political Economy: Politics, Patronage and Profits and Studwell’s Asian Godfathers: Money and Power in Hong Kong and South East Asia),
3. Malaysia’s economy is largely dominated by government-owned companies. Among the 10 largest companies by market capitalization listed on Bursa Malaysia in Sept 2020, 6 have the government as a major shareholder: Tenaga Nasional, Maybank, CIMB, Petronas, Axiata and Sime Darby (see also Gomez et al’s Minister of Finance Incorporated: Ownership and Control of Corporate Malaysia). Significant government ownership means that Malaysia’s national (or political) interest may drive corporate decision-making, rather than shareholder return. If anyone needs a case study in how government-linked companies can be mismanaged: remember the FGV saga?

All of this taken together means that (similar to Singapore) the top tiers of the Malaysian stock market are typically filled with rather conservative family or state-owned firms engaged in financial services, utilities or plantations. There are no Googles, Samsungs or Tencents to drive growth like in the US, Korea or China. In such an environment stock-picking might actually be a way to consistently beat the stock market index because it would mainly involve avoiding the “dead wood” state- and family-owned businesses.

Running the Numbers

So how do we test this theory? Lacking access to any fancy data sets from Bloomberg or Reuters, I used the Fund Selector function from FundSuperMarket (FSM One), a discount local mutual fund brokerage. If selecting funds with asset class Equity and their geographic focus on Malaysia around 62 funds provide a total return figure (capital appreciation + dividend) for the past 10 years. Of those 62 funds, 25 are Shariah-compliant funds (including 1 index fund) and 37 are conventional funds (including 2 index funds).

There is a large difference between the conventional and shariah funds in terms of their holdings, and that difference is financial institutions. Most of Malaysia’s large banking groups (Public Bank, Maybank, CIMB) have a conventional banking unit engaged in usury (conventional interest-baring loans, which aren’t allowed under Shariah) and so are removed from the Shariah funds. For this reason its meaningful to make separate comparisons between conventional managed funds vs. index funds and Shariah managed funds vs. index funds.

Finally it must be noted that the index funds must invest in large-capitalization stocks (all follow the relevant FTSE Bursa Malaysia index) whereas managed funds can and do invest in smaller and medium-capitalization stocks. And there could be some survival bias: poorly performing managed funds may have been closed down. Nevertheless, we attempt a comparison…

From the results it appears that in both categories (conventional and Shariah) the managed funds on average outperform the index funds. For conventional funds this gap is 3.61% but for Shariah funds its just 0.12%. So in that sense our hypothesis of Malaysia being different from North America and Europe, seems to hold, although for the Shariah funds, only by 0.12%, which may be within the margin of error.

Also noteworthy is that the Shariah index fund (average +5.12%) has significantly outperformed the Conventional index funds (average +1.98%). Taken over 10 years, that’s a stunning gap of 31.4%. If you had put your money in a Fixed Deposit you would probably have beat conventional index funds over the last 10 years. Ouch!

Fund Type	10 Year Average Annual Return
Conventional Index Funds (2 funds)	+1.98%
Conventional Managed Funds (35 funds)	+5.59%
Performance Gap	+3.61%

Fund Type	10 Year Average Annual Return
Shariah Index Fund (1 fund)	+5.12%
Shariah Managed Funds (24 funds)	+5.24%
Performance Gap	+0.12%

Analysis

So how can we better understand these surprising figures of out-performing managed and Shariah funds compared to the conventional index funds?

Two quick explanations come to mind. First, the conventional FTSE Bursa Malaysia KLCI index contains 3 large financial groups which are not a part of the Shariah index. Those financial institutions seem to have been a large drag on the conventional index funds’ returns.

Second, the fees of the index funds are substantial. Whereas many popular index funds in North America or Europe charge around 0.2% in management fees, the fees charged by Malaysian index funds, especially the conventional ones, are high. RHB’s KLCI Tracker charges 1.50% per year (comparable to a Malaysian managed funds) and Principal’s KLCI-Linked Fund charges a little less, but still 0.95%. PMB’s Shariah Index Fund only charges 0.60% as a management fee, which makes a big difference, especially when they compound over the long term.

Therefore the out-performance of Malaysian managed funds during the past 10 years seems to be largely explained by their ability to avoid investing in some large but under-performing stocks which may have structural governance issues by virtue of their family ownership, government ownership or some kind of political exposure. A profit-maximizing fund manager may therefore be able to avoid these stocks, but they nevertheless dominate the index because the size of the firms and ownership by government investment funds keeps their market capitalization high.

So what’s a lay investor to do? Well, managed mutual funds may not be a bad way to invest in the Malaysian stock market after all. Now the next challenge: figuring out which ones to buy.

Disclosures

The data used to make the calculations is available here.

I am a customer of FSM One and own fund(s) that were included in this analysis but I did not receive any compensation from FSM One, fund managers or any other related party in relation to writing this piece.