BY BRUCE SHEPPARD
Bruce Sheppard's Stirring The Pot: Investing in managed funds
The simplest way to think about managed funds is as equities and a business in their own right. They pool capital and manage it for profit.
It is a business for the manager, they receive fees and these businesses are quite valuable, so by default what they do with your funds is also a business.
The business of a fund manager is selecting promising business either based on their judgment or as part of a planned process for investing in businesses. Some managed funds choose to run a business of speculating on markets, or commodities or whatever, and plan their business acquisition strategy and disposals around movements in the market.
Forget all this crap, just use the skills you need to buy a business to determine if you would buy a unit in a managed fund.
The offer document for a managed fund will be fairly limited compared to that of a company raising equity, and the reporting will also be pretty limited. That said, the complexity of activity of managed funds is also fairly limited.
Mostly these funds will have an investment plan, they will be buying property, bonds, mid-cap equities, top 10 equities, international equities. They will be allowed to deploy debt or they won't be. They will have a manager who has a fee structure and this is the essence of the business of a managed fund.
If you believe the story and the people look smart and trustworthy, and if it looks like there is no moral hazard obvious in the structure, then you can consider buying a managed fund just like you can consider buying an equity so long as it is cheap relative to its performance. Valuations of equities are another article, but suffice to say it is rare that such funds are cheap.
The plus of managed funds is that you don't have to think about the underlying prospects of real businesses, all you have to think about is whether the strategy that this particular fund has for investing in businesses makes sense to you, and whether over time it appears to have worked. On this basis look at what the likely future passive income will be, and whether this promise of returns is competitive compared to other opportunities for return.
The plus of managed funds is that you pool funds, or perhaps even have the option of drip feeding in small amounts over time, so that you spread your risk over many businesses. This said you can do this with equities if you execute your investment plan rationally, but it is much harder to do this with property. Note also that small investments have a higher fee cost relative to the sum invested than bigger investments.
With equities each buy or sell has a transaction fee of $7, this is charged on $1m or $1000. With managed funds it is the same, but worse, the costs of small investments can be up to 8 percent on entry. This said this will be disclosed so you can do it with your eyes open.
One of the negatives of managed funds is that you ultimately trade off liquidity, and you are putting another layer of people between you and the customer's wallet. Remember the more people between you and the customer's wallet, the higher the costs and the greater the chance of human error, fraud or inefficiency.
There are many types of managed funds I will cover as many as I can think of, but understand this, I have never invested in a managed fund ever. I have some clients who do, despite me trying to talk them out of it. Some are happy with the perceived security - most are disappointed with the performance.
The first question to ask is this: is the fund a closed fund or an open fund? A closed fund is one that is seeking a fixed amount of capital, and will then usually list on an exchange but will not offer redemptions. The liquidity of these is predicated on the willingness of new investors to buy old investors out in the market. There are very few closed funds in NZ, and mostly these are run privately and off market by private equity syndicates.
For example one broker firm runs closed private equity funds for people to pool money to invest in private companies. I have not invested in these either, however one client who did and has done so for many years has done very well. These funds are closed and usually fixed term, never less than five years.
You cannot get your money out early and you have to be a habitual investor to participate, meaning more than $2m of assets or more than $200k annual income or you have to be investing $500k in the individual offer. The presumption of Securities law is if you have $500k to throw around you don't need protection.
Until the FIF regime came in there were a number of closed funds operating out of the UK which could be bought on NZX. The FIF regime drove them out of our market but they can still be bought. If you buy these you may (there are thresholds) pay tax on 5 percent of the open market value whether they pay you any thing or not.
Open funds are funds that take money in directly and all the time. The have a unit buy price and a unit sell price. The buy price is the price you pay to buy a unit and sell price is the price at which they will redeem a unit if you want your money back.
The units are revalued each week (usually) to reflect the underlying value of the assets in the fund, an entry fee is added to arrive at the buy price and an exit fee is deducted to arrive at the redemption price. Have a look in the newspaper at fund manager returns over five years and also look at the buy-sell spread as an approximation of entry and exit fees. Sometimes you also have to pay fees as well.
In a market that is moving upwards gradually and perpetually, the plus of these funds is guaranteed liquidity and a guarantee that you will receive the fair value of the asset you have invested in less the exit fee. With closed funds they behave like shares - sometimes they are cheap and a seller does not get the underlying value of the assets.
Open funds however have an inbuilt liquidity hazard on a falling market. When the markets fall, the unit values drop, then they have the unit holders asking for their money back.
It is a bit like finance companies with short maturity debenture stock on issue; when the confidence goes you end up with a run on funds which naturally accelerates.
The fund managers thus has to hold cash to deal with redemptions, so this builds in a level of inefficiency into open funds, and when the cash runs out they have to sell down their investments in a falling market thus accelerating the fall in the general markets. Sometimes they have to do really hot deals off market.
What this means is that those who stay in the fund are punished by liquidity, and eventually the fund manager has to suspend redemptions. At this point there is zero liquidity. Open funds are very dangerous in falling markets, and more dangerous than owning equities directly.
Funds are further categorised on what they do, and generally they fall into two categories, with many sub sets. The first are passive or index funds and the second are active funds.
Index or passive funds are mostly buy-and-hold equities or whatever to mirror one or other index. Some do this same task by using derivates, i.e. futures contracts on the indexes themselves. They rebalance periodically to deal with the ups and downs of the market so that they get close but not exactly aligned with the movements of an index.
Mary Holm actively promoted Index funds before she got KiwiSaver to play with. Index funds are fine in a rising market but in a falling market, the tide is guaranteed to go out on your portfolio.
If you choose to play with buying and selling index funds, you need to try and second guess markets and economic outlook in general and if you think this is easier than understanding a businesses prospects , you are dreaming.
The big patterns around human activity for the next 15 to 30 years are generally negative particularly in developed economies, Index funds are thus a road to poverty in my view. The plus of index or passive funds is low fees, the manager just has to apply the formula and stick to the plan, he doesn't have to think.
Active funds actually try to out guess the market, some are market traders, some are growth investors, some value investors, and the pitch to you is that they can do this better than you, and thus deliver a superior returns. Ok that is a business, and can be judged as a business, and its units can be bought or sold on normal valuation principles. This said if they are an open fund they then attract more money , and the more money they attract the less active they become. In the words of Jim Slater, "Elephants don't gallop"
Managed funds do however have a number on inbuilt moral hazards and there are virtually none that do not have one or all of these moral hazards built into their structure. These moral hazards if the funds are listed usually mean that the fund trades at a discount to asset backing. Eg the property funds, and always will until the management contracts are terminated. All managed funds have a less than transparent governance structure.
Now to the inherit moral hazard.
In equities the payment for services also creates a moral hazard but it is different in managed funds. With equities, due to better functioning boards, and the nature of the contractual relationship with management this hazard can be dealt with more effectively. With managed funds the nature of the contract creates an enduring and very valuable asset for managers, and board processes and contractual arrangements devised on set up make it impossible to regulate reward or even manage the team.
Most managed funds have a fee structure for the mangers based on funds under management. Some in addition also have success fees on top. The rational for the fee based on assets is that it is intended to cover the real costs of investment and provide a wage for the management team or a return to the owners of a management company. Success fees on top are designed to share success, defining success also sometimes creates a mismatch between unit holders and managers. However this is the same for equities, if rewards are misaligned with owners' expectations.
Some managers of these funds are exclusively rewarded by a fee based on assets. The alternative is a flat fee structure, which of course doesn't accommodate growth in the funds and thus the required amount of work, and for small funds means that the fee cost to assets is too high. In many respects closed funds are better, as they take in a sum of money, work out how much it will cost to run the money they have got and draw a fee equal to cost, perhaps expressed as a percentage of assets. This means that as the asset value grows the manager derives more fees - there is nothing wrong with that, the asset value has grown.
With property unit trusts the fee structure often also includes an ability to obtain cost reimbursements or commissions or fees upon the leasing or acquisition of properties.
There is no perfect reward system for managers and all create a moral hazard due to a mismatch between managers and owners expectations particularly over short and long term objectives. The role of boards is to balance this out. In many ways it is the most important task they have, but the one that often gets the least attention. In managed funds the board structure itself is flawed, more on this later.
The most common reward structure for base fees is the percentage of assets method. When combined with open rather than closed funds this creates a food chain that works against the interests of unit holders.
On day one there is one unit holder who owns $1000 of capital and pays the manager $25 in fees. The fund makes $200 during its first year after fees and the unit holder is happy. He has received nothing, as profits are reinvested. The fund's value is now $1200. The fund now attracts fresh capital of $1000 on the back of this success so the fund now has a total of $2200 and the mangers fee in the second year is $55.
In the second year the fund makes another $200 not such a good return so the manager who has the power to borrow raises debt of $1500, the fund commences the third year has $3700 under management and the fees have grown to $92.50. The business of the fund manger is valued at say three years income, so in the first year the fund managers business is valued at $75, by the end of the second year it is valued at $277.50. The fund itself has produced $400 of value spread across $2000 of capital and the mangers have derived fees in cash of $80 over the same time frame plus a market value asset of $277.50 has been created.
Thus the first moral hazard is created, which is the drive to attract the most money as possible and grow the total or gross value of the fund. This said, the managers are realistic. They know this only occurs if they can attract money from the market and retain the money they have got, thus they focus on how to increase the unit holders' disclosed value, as the better they perform the more money investors will give them.
As the amounts involved are significant, as shown above, and out of all proportion to the economic performance of the funds, the incentive on gross assets creates a natural desire to maximise debt. This increases the return to the manager, maybe to the unit holder too, but the unit holder carries most if not all of the risk. The next issue is the incentive to fraud, or window dressing results. You have seen the Huljich KiwiSaver fund issue. If you can pump cash into the fund and call it income, the consequences in fund attraction are out of all proportion to the cost of a few dollars of cash to bolster results.
The other thing that can happen is market manipulation. Say you hold a share that can be bought on market for a $1, and another fund holds a share likewise with a price of $2.
The fund manager thinks that share one is worth $2 and share two is worth $3, but they cannot reflect this in their books. If they can do an off market trade with each other, they can increase their profits by $1 each, which results in attracting more funds and adds $1 each to their asset base, which means they can increase their fees.
Off market transactions, funnily enough, occur most often at the end of a reporting period, but to cover their tracks they conduct activity on market to build up to or down to the price they want to trade at and the big sale happens off market. Now not all these transactions are motivated for the fee building nature that is the consequence but it is an obvious moral hazard.
Cost recovery fees. Without good governance and checks and balances these too can be manipulated. For example if the manager gets a fees on releasing property in the fund, the incentive is to have short leases and high churn, not good for asset values however. If managers are paid on acquisitions this is an incentive to look at an awful lot of stuff that you don't buy.
The remuneration moral hazard in managed funds is considerably higher than in direct equity investing.
One final point on remuneration. Managed funds normally sign long term contracts with managers. These are written before you ever put a dime in. Normally they are structured to protect the manager who is also the promoter when he issues the prospectus asking for your money, and terminating these is nigh on impossible without having the fund write out big cheques. There has been plenty about this in the paper recently too, with much wailing and teeth gnashing from investors. But frankly they were dopey buying the fund in the first place. The evil in this case was the financial planner who also had an interest in the fund manager. As I have said before the more people between you and the wallet the more chance for a skim.
Now to the governance of these funds. There is the fund itself, which is usually a unit trust. It will thus have trustees appointed for the unit holders these however are nothing more than custodians, and may if you are lucky, be given some powers to ensure that the manager operates the fund in accordance with whatever they have said they will do. These trustees are the same people who looked after your money in the finance companies. They cannot be easily removed by unit holders, and even if they are removed their powers are defined in the trust deed which was written before the fund went to the public to ask for money, by guess who, the promoters who are usually the managers. The managers pay them as well.
The board of directors of these funds are not a board that you get to appoint or remove as unit holders. Trusts do not have boards. It is a board of the management company appointed by - you guessed it - the managers.
So the only meaningful thing you can do in a governance sense is vote the manager out. Remember they wrote the management contract so if you do this they normally get a parachute. But before you can do that you have to call a meeting. That is sooner said than done and even if you do get one called to remove the trustee or the manager it would require a 75 percent resolution. The governance of most managed funds and particularly those structured as trusts, is completely ineffective.
So excessive moral hazard, expanded liquidity risk, and poor governance is the additional risk you take on board to achieve a spread of asset ownership. If you really must invest through managed funds pick ones that:
* are closed rather than open.
* are structured so that you get to appoint as owners of the FUND, the directors.
* the management contract does not have an excessive parachute.
* the management contract can be cancelled by the board on notice and does not require a meeting of unit holders.
* the management contract is for a fixed base fee, not a percentage of assets.
* The manager's performances incentive is based on income and or real asset growth not bought asset growth.
* the board has a sound track record and no baggage.
* incentives are used to purchase units in the fund.
* the manger has invested a significant amount of his own money in the fund.
Good luck with that.
And guess what team? Successive dopey governments have created the PIE regime and KiwiSaver which is the largest transfer of wealth to the private sector funds managers ever in NZ. All KiwiSaver accounts are parked in funds that have all these problems, and the sooner they bring on self managed funds the better. I am not a KiwiSaver and will not be until I am entitled to manage my own wealth.
Next blog is borrowing for investing.
Read Bruce's disclosure here.