Where do you trust your money…
Pathfinder executive director John Berry goes on a mission to find out about managed fund disclosure and finds it is very difficult to get the full picture on many things, especially fees and securities held. Here is his checklist.
Tuesday, November 12th 2013, 9:31AM 2 Comments
by Pathfinder Asset Management
It is a surprise when your understanding of the world proves to be completely wrong. The 17th century Europeans believed that all swans were white – but this belief was shattered with the discovery of Australia which was teeming in black swans (and hence the title “The Black Swan” for Nassim Taleb’s excellent book).
Last week I was shocked to discover that the peanut is in fact not a nut at all – it is a legume (the bean family). A cashew nut is not a nut either. Crazy. The world of fund management can also be filled with “black swan” and “peanut” moments - an investment may not always be what it seems. In this commentary we look at the steps investors and advisers can take to protect themselves and understand what they are investing in.
When it comes to racing, sailing relies on a strict code of honesty and self-policing. That is why the discovery of cheating in the pre-America’s Cup AC45s was taken so seriously and punished harshly. When it comes to investing in funds don’t rely on everyone to be self-policing. Do your research - here are 6 steps to go through before handing over your money.
1. Demand transparency – identify the underlying assets
Bernie Madoff was never one for transparency of his investment holdings (US$64 billion of which were fraudulent). When challenged at meetings with questions around exactly what the money was invested in to earn such consistent returns he would say something like “if you don’t want to be “in” then this meeting is over”. It is hard to cheat when everything is transparent.
Without transparency you do not know what assets your money is invested in. Would you expect to see a short S&P500 position or a Gold ETF in an income fund? (yes really, I am not making this up!). Or for an international fund to have 4% of its listed investments suspended from trading? Find out from the manager exactly what assets are held.
It is not just the actual assets currently held that is important. You also need to understand the eligible investment universe. Ask what the fund is allowed to invest in – you don’t want surprises. For example would you expect a mainstream NZ equity fund to be permitted to invest up to 30% in unlisted equity? (well at least one can…). Investors offshore were shocked to find bond funds were outperforming indexes by investing in dividend shares – they are often allowed up to 20% in equities.
2. Demand transparency – understand the underlying assets
Too often investors have trusted the people or brand without understanding the assets really invested in. How many investors in finance companies understood that they were typically funding not just property lending but the riskiest portion of property developments (and weren’t getting paid appropriately for taking that risk)?
Understanding the underlying assets means asking questions like are the assets liquid? Are they leveraged? Are derivatives involved (not at all fatal, but you need to assess the risk including credit risk on the counterparty). Do the assets have currency exposure?
Let’s take liquidity as an example. If you want to be sure you can get your money out of a fund then you need to know that the underlying assets are liquid (meaning they can be traded on a market and there are likely to be plenty of buyers quoting a fair price). The problem with liquidity of markets is that you don’t truly know how liquid a market is until it is tested – and that is probably the exact point many investors will want to sell. Investing in international shares is not a guarantee of liquidity – one NZ international share fund locked up for a short time after 11 September 2001 because the offshore fund it fed into suspended redemptions.
3. Understand the fund fees
Too often in an Investment Statement the management fee is described as something along the lines of 1.0% plus expenses plus performance fees. This isn’t helpful information for investors because it doesn’t tell you the total fund fee burden.
You often need to also read the Prospectus to understand the fees. Combining information in both the Investment Statement and Prospectus in one equity fund we get the following:
Manager base fee | 1.29% |
Other expenses | 1.09% |
Performance fee | 0.78% |
TER | 3.16% |
The total fee burden should be easily accessible information - but for this fund you will not see it in the Investment Statement. In fact the final fee is more than double the manager fee disclosed in the Investment Statement.
Advisers should not only demand full disclosure, they should also demand a cap on total fees charged – an approach now used by a number of managers. This means you will know how much the “other expenses” component will be (note performance fees are not generally capped – although they are in some kiwisaver schemes).
4. Check for structure and process
Investor focus on fund research is too often on the quantitative side – how well has a fund performed over the last 3 years? But the best information that a research house such as Morningstar, Lonsec or Fundsource can give you is not “quantitative” but “qualitative”. What you need is a view on whether the manager has appropriate processes in place.
Does the manager have an objective and consistent process for reviewing its investment universe? Does the manager understand and identify risks, and take steps to mitigate those risks? Are the controls robust? To answer these questions the research houses will spend hours meeting with a manager – they will review process and systems on site. The qualitative explanation of process from a research house gives some of the best information on which to base your investment decision.
5. Check there are independent service providers
David Ross not only held assets for his clients but he also priced them himself. What was recorded as $380m of assets was in fact worth only a small fraction - the lack of independent custody and independent portfolio pricing helped him hide his deceit.
Be very wary investing in a fund if there is no independent trustee, custodian and fund accountant – these are simple but essential protections. (The exception is where some large institutions in New Zealand do their own in-house fund pricing - if you trust the brand to do the right thing then you may overlook the lack of independence. With a small operator you overlook independence at your own risk!).
6. Check out the directors
Directors provide an important oversight for fund management businesses. What you want is for directors to be committed and to fall into one of two camps:
• independent; or
• not independent but have their personal interests aligned with investors.
If a director is not independent (i.e. they are a shareholder in or employee of the management company) then how do you know if their interests are aligned with investors? The simple check is to see if they invest their own money in their funds – managers should not be embarrassed about disclosing this. You don’t need the exact dollar amount, you just want to know it is enough for the manager to really care about.
One research house commented that too many fund managers were reluctant to disclose how much their non-independent directors invest in their funds as it is simply not relevant. However upon being pressed on the issue it is generally found there is no investment at all in the fund – this is relevant information. How well aligned are the interests of such a manager with investors?
7. Final thoughts
What does this tell us? Below are some points to ponder:
Don’t just read the Investment Statement, read the Prospectus as well: The two document structure for fund offers is unwieldy – particularly given that Securities Act requirements make the Prospectus a poorly structured document. However there is always information in the Prospectus that does not appear in the Investment Statement – the product description, fee description and identification of risks is always more thorough in the Prospectus. You must read both.
Transparency is critical: You cannot find a black cat in a dark room - you need the light on. Turn the light on when you review funds – make sure you have transparency. Ask the manager to explain the underlying assets in a fund – ask to see a list of holdings. Ask about the wider permitted investment universe. Ask about fees, leverage and liquidity. Go beyond the offer documents to search out information and understand what you are really investing in.
Process is important: Manager process around selecting investments and managing risks is important. Manager’s should work within a consistent and well thought out framework. Read fund research papers to understand a manager’s process (don’t just read the past returns part of the research).
Not all funds are made equal: There are a number of structuring choices a fund manager can make when building a fund – you need to understand the decisions made. Not all funds are the same, and this is particularly true when a fund of funds structure is used. For example with an international equity PIE fund that directly holds shares the manager should show you the underlying holdings. With an international equity PIE fund that invests through an offshore manager do you know whether the portfolio includes unlisted stocks or if equity exposure is through derivatives rather than stock holdings? Do your research and ask questions.
John Berry is an Executive Director at Pathfinder Asset Management Limited.
Pathfinder is a fund manager and does not give financial advice. Seek professional investment and tax advice before making investment decisions.
Pathfinder is an independent boutique fund manager based in Auckland. We value transparency, social responsibility and aligning interests with our investors. We are also advocates of reducing the complexity of investment products for NZ investors. www.pfam.co.nz
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Comments from our readers
However the same observations could be made about advisers. How many advisers clearly show clients their total expense ratio? How many target, track and report performance from a clients perspective net of tax and fees?
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I did ask many managers, received little meaningful response so moved on to somewhere I did get this. I can provide the names and holdings of all 5,000 publicly listed stocks, turnover, all fees, investment style, etc, etc. This is really nothing special, it's my job.