Beware of the writedowns
Managed funds are a great way for New Zealand investors to get access to professional investment skills and a broad range of assets, but they are not always foolproof.
Friday, October 8th 1999, 12:00AM
In two cases managers have inflated the unit prices of some funds by adding in the value of tax credits from previous losses that have subsequently become unrealisable. The end result is that up to 40 per cent of unitholders' value has been wiped off with the stroke of a pen.
The third example is the on-going struggle for survival of the $75 million New Zealand Rural Property Trust. This is the sad saga of a once-popular fund that has been hobbled by fundamental structural problems, and a weak rural sector.
Investors presently in the fund have to decide whether it is going to eventually emerge from its long coma, or whether it is terminal and the plug should be pulled at a special meeting.
The manager, Williams and Kettle-owned New Zealand Rural Property Trust Management Ltd takes the former view and is proposing to close the trust and remove unitholders' redemption rights for five years, however there is an "Action Group" of unitholders who strongly oppose the plan.
NZRPT's closure proposal is multi-faceted and includes many other issues such as management fees, governance and a capital repayment. Consultant PricewaterhouseCoopers describes it as "far-reaching" and says if approved investors would be "giving up a significant right".
One thing all parties agree on is that the open-ended structure where the manager redeems units at net asset value on request is unsustainable because the fund's assets are large and illiquid.
In this case the fund has mirrored the primary sector and been doing poorly for a number of years and to redeem units the manager has had to sell farms in a depressed market.
The shortcomings of open ended property funds were starkly exposed in Australia during the early 1990s. Then a rush of redemption requests nearly crippled the managed fund industry.
While all parties agree that the NZRPT should be closed and unitholders should redeem their investments in a market, there is bitter disagreement over how this should be done.
The manager insists unitholders wanting out use the secondary market run by Sharemart, however the problem there is that over recent times trades have been made at half the net asset value.
PricewaterhouseCoopers insist, in a trustee-commissioned independent report, that listing the trust on the New Zealand Stock Exchange would give investors improved marketability and therefore better value. This is a proposition that has been made in previous independent reports and by research house IPAC Securities.
Yet the manager argues against listing, citing the trust's small size, its lack of distribution history and the fact that the primary sector is out of favour with investors.
"These reasons are all existing circumstances, that affect investors and the value of their unitholding at the present time, whether or not units are listed on the NZSE," the PricewaterhouseCoopers report says.
From the small investors point of view this situation is exacerbated as control of the trust essentially sits with a group of unitholders that are either associated with, or supportive of the manager. This group, which own about 25 per cent of the units and includes Tainui-owned MDC Investments, have indicated to PWC they do not support listing.
The other concern for unitholders, and it is raised by PricewaterhouseCoopers, is that unitholders are only being given one option to fix the trust when there are others which should be considered.
PricewaterhouseCoopers say an orderly wind-down of the trust is the base case scenario against which any other strategy should be evaluated.
However the major unitholders "do not favour a wind-down of the trust at the present time and that any resolution to this effect is almost certain to be defeated."
Unitholders could expect to receive between 92 and 99c a unit under a wind up, PWC says. This is about halfway between the net asset value of $1.25 (May 31) and the average secondary market price of 64 cents.
The New Zealand Rural Property Trust story is a case study of why open-ended funds that invest in property don't work. It's also an example of how unitholders have little influence over the manager. In this case many of the 4700 investors, research houses and independent consultants have been arguing the trust should be listed to give the unitholders a better market to trade their shares, yet the manager stubbornly refuses to do so.
Another managed fund issue the NZRPT closure proposal raises is the level of management fees. To sweeten the closure proposal the manager is offering to reduce its fees and make them "performance related" as well as make a 17 per cent capital repayment.
Instead of a 2 per cent annual cash fee, the manager is offering to split the payment into two components: cash and units issued at NAV, however the total fee is still based on the size of the fund.
PricewaterhouseCooper's analysis of the proposal and comparison with other property holding investment vehicles show that the fee is relatively high, even taking into account the relative size of the trust and the geographic spread of assets, and the changes make only small changes in the fee's monetary value.
PricewaterhouseCooper's other concern is that the "performance related component" does not efficiently align the manager's incentives and rewards with the interests of unitholders.
The fee still remains closely tied to the fund's size, rather than to its performance. This is a real issue for unitholders considering the recent poor performance of the trust and its decline in value.
"Our preference for a restructured management fee would involve linking a material component of the manager's remuneration to a measure of increased unitholder value, rather than the entire fee being tied to the size of the trust's asset base. Ideally, under such an arrangement the performance component of the manager's fee should only become payable where unitholders received a total return (income plus capital appreciation) that reflects a rate of return exceeding the appropriate cost of capital measure."
IPAC Securities general manager David van Schaardenburg says fees are a big issue for the industry as they reduce an investor's return. While there is talk of moving to performance based fees, one has to be careful of the details. In some past cases the benchmark the manager is measured against is low, and often the fees are structured to give the manager rewards on the upside, but no punishment on the downside.
Perhaps the irony of the overall closure proposal is that PricewaterhouseCoopers label it "fair and reasonable", not because it is flawless, but "primarily because the present redemption arrangements are proving unworkable, and likely to eventually be inequitable as between unitholders."
TAXING PROBLEMS
The other problem that has surfaced is the practice of managers rolling up the value of tax credits from previous losses in the unit price.
This has happened with two of the former Direct Funds Management (formerly Renouf Asset Management) equity funds, and three Prudential unit trusts that are now owned and managed by Colonial First State Investments.
In all these instances the funds had made significant losses in previous years when markets, and fund performances were poor. The losses made by the funds meant they then gained tax credits which could be used to offset future tax liabilities, as long as the fund kept a reasonably consistent unitholder base.
The Direct international fund had losses of 33.72 cents per unit (cpu), at March 31, and the New Zealand equity fund had losses of 20.65 cpu. The fund's accounting policies were subsequently changed so the tax losses would not be included in the unit price.
Under the change the International fund's price fell 41 per cent from 90 cents to 69c and the NZ equity fund price fell 23 per cent to 48.5c.
Direct was keen to keep the funds going by using a new manager so investors could enjoy the benefits of the credits when performance improved, however that has only happened with the International fund which is now managed by Australian-based Dresdner RCM Global Managers.
Direct has been forced to close the New Zealand fund because more than half the unitholders have exited it. Under tax rules the credits only stay with the fund if there is a set degree of unitholder continuity.
"The availability of these benefits was dependent upon 49 per cent unitholder continuity from April 1," director Stephen Underwood says in a letter to unitholders.
Because of the redemptions the fund has lost the credits and has become so small it is no longer viable, he says.
Colonial First State Investments is in a similar situation with three of the ex-Prudential funds that have been included in its recent product rationalisation.
The New Zealand Equity Income, Japanese Opportunities and Asia Pacific Opportunities funds all have had their unit prices written down by up to 20 per cent because of a similar situation.
Details of the writedowns aren't clear, and Colonial First State Investments chief executive Bruce Abraham refuses to discuss the issue and explain the circumstances.
However in a letter to advisers Colonial says the prices it has struck for the funds is based on "the proceeds from realisation after taking into account the anticipated liabilities of the trusts."
"For some trusts this has resulted in small increases in unit prices, for others it has lead to reductions in the unit price. For one fund, the Equity Income Trust, this has lead to a significant drop in unit price."
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