New laws fall short around fund fee disclosure

Financial Markets Authority CEO Rob Everett. Photo / Supplied

Regulators and politicians publicly wring their hands and despair at the fact that many New Zealanders choose to invest in residential property rather than "productive" investment in the stock market.

Anecdotal evidence suggests that one of the main reasons many New Zealanders prefer residential property over share market investment is that, with residential they control more of their investment decisions whereas with shares or managed funds control is ceded.

The Financial Times neatly summarised some of the problems with the finance sector the other day when it said "asset managers still stand accused of putting their profits before their clients, investors remain unsure as to how much they are paying for the funds they are invested in, and many active managers continue to make grand claims about beating the market and, well, don't".

These are themes this column has explored many times over the years.

The Financial Markets Authority (FMA) has recognised that "trust" is an issue and has been working hard to restore retail investor confidence.

In a statement FMA chief Executive Rob Everett, when commenting on the Milford employee share market manipulation court case, recently reminded financial market participants of the FMA's "core objective of promoting fair, efficient and transparent financial markets".

We are now being told however that new laws have sorted out many of the problems. Last month the FMA noted that the new Financial Markets Conduct Act means an improvement in the regulation of the financial services sector.

The FMA says that investors had certain rights to information which would "help them deal more confidently with their providers and help them make more informed decisions about their investments".

The FMA believes that one of the key investor rights is knowing how much you will pay in fees and that these should be clearly set out.

The Commission for Financial Capability also drank the Kool-Aid and said "we can expect them to explain clearly what we are paying for and how much" and "knowing the true cost of what we are getting into can't be too much to ask".

So the FMA and the CFFC say that investors can now confidently expect that they will be told the full story as regards fees on managed funds.

That sounds convincing but unfortunately just saying something doesn't make it so.

Today we will take a closer look to see whether the politicians and regulators have done enough to offset the information asymmetry that exists whereby fund managers know everything and retail investors know not so much.

First some background: unless you are on the rich list one of the key considerations when buying a major item like a house or entering into a 30-year savings plan with a KiwiSaver provider is how much it costs.

When you buy a house the more you pay the more you get but in the investment world the opposite can be true - the more you pay the less you get.

The bad news is that despite the new regulations and assurances by the FMA and the CFFC, total expenses in respect of managed funds like Kiwisaver, are still not being disclosed.

The reality of the new improved disclosure laws in my view is that there is a material omission in fee disclosure. Read on.

One of the big costs involved in owning a managed fund is the charges that the fund managers incurs on your behalf where he or she pays a stockbroker to buy and sell securities in your managed fund.

One of the reasons you buy a managed fund is because you think the fund manager will use his/her skill to, for example, buy Fletcher Building if he/she thinks it's cheap and sell Auckland Airport if it is viewed as expensive. These transactions cost money in terms of brokerage payable to the stockbroker and the bid/offer spread.

Despite the "high-fives" the new Financial Markets Conduct Act does not require that brokerage costs be disclosed.

This is extraordinary because non-disclosure of brokerage costs is a material omission.

The UK regulator estimates that UK fund managers spend around £3 billion ($5.3b) a year of client's money on dealing commissions. That is a lot of money and it is an issue in NZ as well.

For example, I looked at one NZ managed fund where brokerage costs were $3.03 million in the year ended 31 March 2016. That $3.0m was equivalent to 1.05 per cent of the managed funds assets so it's a very big deal.

The website of the Securities Exchange Commission (SEC) in the US, the equivalent of the FMA, estimates that each 1 per cent in annual fees reduces the terminal sum over a 20 year saving period by 18 per cent. So the impact of this undisclosed 1 per cent a year fee over the long term is likely to be huge.

Turnover costs and their impact on managed fund investor returns are not new. Indeed this column wrote about the issue back in 2003. Then we noted a Vanguard study which suggested that turnover costs in the average US managed fund typically reduced investor returns by 0.6 per cent a year. It is therefore extraordinary some 14 years later that this information is still withheld from NZ retail investors.

So whilst the FMA might believe "you are entitled to know how much you are paying" the reality is that the law simply does not require full disclosure.

Not only does the law not require this information but the ex-minister in charge of the FMA, Paul Goldsmith, doesn't see that as a problem. In an email he said, when discussing the new regulations, "investors are now given the full picture of all the fees they pay in the Product Disclosure Statement".

However, in a further email he said "brokerage costs and other transaction costs are not disclosed in the Product Disclosure Statement".

This is good stuff even by the standards of normal political rhetoric.

Best practice internationally increasingly reflects common sense and regulators are requiring investors be told the whole truth rather than half-truths.

When you get a quote to paint your house a reasonable person would be justifiably upset if he/she accepted the quote, got the job done, paid for it and then found that the quote didn't include the cost of the paint.

Why should financial markets be any different?

In the UK, the regulator is taking its responsibilities to retail investors seriously. The UK watchdog found that only one in five investors knew they footed the bill for trading costs. The FCA found that trading costs were a material cost and they estimated that "an investor in a typical low-cost passive fund would earn 25 per cent more over 20 years than an investor in a typical active fund" due to the fee differential.

Once transaction costs have been taken into account the FCA estimated that the passive fund would be 44 per cent ahead.

Therefore, in a complete review of the sector the FCA will be requiring UK fund managers to include transaction costs in the single figure estimate of their annual costs.

In contrast these fees aren't disclosed locally. For example, the Sorted website discloses the annual fees of Kiwisaver funds but this does not include the transaction and other trading costs.

Recall the FMA's "core objective of promoting fair, efficient and transparent financial markets". A reasonable person would conclude that non-disclosure of material costs does not meet this objective.

- Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request. Brent Sheather may have an interest in the companies discussed.