Brent Sheather: Investors still stuck with poor performance fees

Photo / Richard Robinson

Two weeks ago we looked at the FMA's latest guidance on performance fees and noted that whilst the FMA has put its foot down about unfair performance fees on some KiwiSaver products it is not able to extend this discipline to all the other local managed funds. NZ investors are therefore going to be stuck with unsuitable performance fee arrangements in some managed funds for a bit longer.

This sort of short sighted action by local fund managers really makes investing in index funds that much more attractive - the computer doesn't ask for a bonus in a good year. Even so the exchange traded funds offered locally could be improved.

Just the other day one of the Smartshares funds, the SmartFONZ fund, fell in price by 4.8 per cent on a day when the market fell by just 0.6 per cent. What happened was that the fund went to a discount to the value of the shares that the fund owned. This is not a good look for an exchange traded fund as one of the biggest attractions of ETF's is that they trade very closely to their net asset value.

Overseas this sort of thing very rarely occurs if ever and, fortunately, according to the NZ Stock Exchange (NZX), the manager of Smartshares, it doesn't happen very often here either.

We must remember however to be grateful to the NZX who are the only institution who have introduced ETF's on to the local market and recognize that demand for local ETF's is not great (ETF's don't pay commission or trailing fees) thus it's not possible to achieve the economies of scale that the Vanguards of this world are able to. However there is always room for improvement and in that spirit we will continue with some more constructive criticism....

The next item on the agenda is, periodically, the very high cost of trading in Smartshares. The spread between the bid and offer of FONZ on the 25 May 2012 was $1.22 and $1.27 respectively. This is ridiculous in what is supposed to be a low cost investment vehicle. A five cent spread on $1.22 is about 4.0 per cent and a huge cost to any potential investor. ETF's overseas are highly liquid and an investor is able to buy and sell at minimal cost, beside brokerage charges.

Now if you dealt with a market maker in FONZ and you had a relationship with that firm you might well have dealt inside the buy and sell quotes but if you were doing your transactions through an online broker you will most likely have been ripped off. I spoke to Smartshares about this and they advised that the wide spread referred to was an aberration and over the last three months the spread on FONZ has averaged just half a cent which on a price of $1.22 is quite acceptable.

Smartshares has however undertaken to keep a close watch on the difference between the buy and the sell quote to ensure that it remains a low cost investment vehicle. Certainly if you compare the half a cent spread on FONZ with the difference between the buy and sell quotes on the locally listed UK investment trusts the ETF's look positively cheap. At 4.02 pm on 6th June the best bid for Bankers Investment Trust shares was $7.86 with the best offer quote at $8.25.

This meant that if you were silly enough to buy and sell quickly you would have bought at $8.25 and sold at $7.86, a difference of 4.7 per cent. It was the same story with City of London, bid at $5.52 and the sell quote was $5.80. Spreads at these levels are a huge hidden cost to investing. So why do these spreads exist? We have to remember that shares in the UK investment trusts are sourced from the UK and often just reflect the wide spread that prevails in the UK market plus an allowance for the costs and risks sustained by NZ brokers who source stock in the UK to supply the local market.

If you are a client of a market maker or you have a relationship with that firm you can often deal inside the quotes but again if you transact via an online broker or a broker that doesn't deal frequently in the UK investment trusts the bid/offer spread can be a big cost.

The third and final area where Smartshares could improve its offering to investors is the issue of lending shares the Smartshares funds own to short sellers. Stock lending involves another institution who, say, didn't like Fletcher Building, borrowing the Fletcher Building shares off Smartshares and then selling them on the stock market with a view to buying them back at a lower price.

ETF's are particularly keen to offer this service as a way of the fund manager making extra money however according to the London Financial Times "operators of ETF's are making increasing sums of money by lending securities". The question the FT asks is what is a fair split of the income received from stock lending between the manager and the fund?

The ETF owns the shares and takes all the risk and the FT reckons international investors are starting to get a wee bit concerned with the split of this income. According to the FT, the world's biggest ETF provider, Blackrock, keeps 35 per cent of the fees, State Street keeps 15 per cent and Vanguard keeps 5 per cent. The NZX keeps a whopping 50 per cent. In their defence Smartshares said that if they had hundreds of billions of dollars under management like Blackrock etc their charges would be closer to those of the offshore giants but in order to get the stock lending process underway it involved the NZX making a substantial investment in terms of systems and documentation.

These three issues probably contribute to the fact that the ETF boom in the US and the UK hasn't really reached NZ yet which is a pity because the inclusion of ETF's in a portfolio really does bring your average cost down so that Mum and Dad gets to keep a more reasonable part of the returns. When the Government finally realizes they have to ban commissions demand for ETF's will increase and the NZX needs to promote Smartshares more aggressively rather than waste time and money trying to list small companies which are irrelevant to almost all investors and certainly make no sense as part of Mums and Dads share portfolios.

Disclosure: Clients and employees of Private Asset Management own shares in SmartMIDZ, SmartTENZ, SmartFONZ, Bankers Investment Trust and City of London.