Managers behaving badly

Regulatory change is painful and time consuming for financial advisers and fund managers. But it is generally accepted that change for fund managers is needed, particularly around disclosure and fees.

Thursday, November 5th 2015, 11:29AM

by Pathfinder Asset Management

Existing Securities Act fee disclosures haven’t worked

In Securities Act offer documents (being a prospectus and investment statement) manager fees are generally described as a base fee plus expenses charged back to the fund. This disclosure has never been satisfactory – why should investors see a percentage charge for the base fee but no percentage charge for the other costs? Disclosure of the total fund cost is much more relevant, particularly given that on occasions expenses recharged are surprisingly high.

Many managers have taken useful steps to address this by charging a capped fee covering the base management fee plus all fund costs. This is a much more meaningful number for investors. ANZ, Milford, Nikko and Pathfinder have each adopted this approach (note for those charging performance fees, this is in addition to the capped fee).

Many managers have retained the approach of disclosing the base fee amount only. To illustrate how the Securities Act disclosure regime is no longer fit for purpose, here is an example of poor fee disclosure by one manager. The manager discloses its base fee for two funds as 1.0% and 1.25%. Various other costs and charge backs are described, but no overall cost ratio is given. The expense ratios for the two funds are not disclosed but can (with some difficulty) be calculated from the fund accounts for the most recent financial year¹. They are extraordinarily high at 9.93% p.a. and 7.85% p.a. Investors don’t stand a chance of making money with this cost structure (mercifully there is no performance fee charged).

The manager fees are particularly high in this case for a couple of reasons. Firstly, the base fee is charged on gross fund assets – which are higher than net assets because the fund uses leverage. Secondly the funds are not large, meaning fixed costs are spread over a relatively small base (but should investors be punished for that or should the manager wear the cost?). Investors need to know the total fee burden, not just parts of it.

Failure to disclose material information

The Securities Act regime sees disclose made through 4 key documents – the prospectus, investment statement, fund financial accounts and fund manager financial accounts. Hopefully all investors and advisers read the investment statement. Some read the prospectus. Almost none read the accounts. A problem with the 4 disclosure sources is that information can be buried in fund accounts (i.e. a document no one reads) and never make its way into the investment statement (i.e. the document investors do read). The new regime makes information more accessible. Here are examples of information currently buried in the accounts:

The financial accounts of one manager disclose that trust deed leverage covenants for a fund were breached in 4 months within one year – shouldn’t that be in the investment statement?
One set of accounts discloses that directors of a manager redeemed most of their units personally held in 2 funds they manage. In one fund the directors redeemed 100% of their units and in another fund they redeemed 53% of their units. Should investors be made aware in offer documents the level of confidence a manager has in their own funds (i.e. how much they personally invest)?²
A manager suspended and later closed one of its funds “while… responding to enquiries from the regulator.” It is also noted that “no provision has been made for any claims or penalties….” for the fund closure – but this does imply FMA penalties are a possibility. Would investors regard the FMA enquiry and resulting fund closure as a useful risk disclosure in the offer document for their other funds?

Inappropriate fund names
There have been no rules around how the name of a fund relates to the assets in the fund. Some funds are positioned more aggressively than their name may suggest – for example allocations in “Balanced” funds can differ widely across managers. One fund that is called a “Performance” fund has lost money in each of the last 4 financial years. $100 invested 4 years ago has in fact turned into only $39. That is not a performance fund – is the fund name appropriate?

Final thoughts

Disclosure changes are being brought in under the Financial Markets Conduct Act and Regulations (FMCA). These are tough for managers to adjust to, but are necessary to protect investor interests. Historically, fund expense disclosure has been inadequate and the industry has not done enough to lift standards. Critical information has been buried in the fund accounts and prospectus, which typically no one reads. Investors deserve better.

Footnotes:

¹ The fund expense ratios have been calculated as follows: total fund expenses for the financial year divided by average unitholder funds over that financial year. The average unit holder funds are calculated as opening unitholder funds plus closing unitholder funds divided by two.
² It is unfortunate that the new FMCA regime has followed the Securities Act on this front – it does not require fund managers to disclose in offer documents their personal holdings in funds they manage.

- John Berry, director of 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

Tags: funds management John Berry