Brian Gaynor: Bonds scheme a winner - for the bank

The Bonus Bonds scheme, which is the country's biggest investment pool, is a massive gravy train. Unfortunately the main beneficiary of this is the investment manager, ANZ National Bank, rather than the investors who "invest" in the scheme.

Bonus Bonds highlights a number of issues regarding management fees and their transparency in New Zealand.

Bonus Bonds commenced in 1970 and the scheme was sold by the Crown to the ANZ Bank as part of the Post Bank sale in 1990. It was a late addition to the Post Bank sale package, much to the delight of the purchaser.

The scheme has in excess of $2.6 billion of funds, all held in the Bonus Bond Trust.

The Trust is managed by ANZ Investment Services (New Zealand), a fully owned subsidiary of the ANZ National Bank and is supervised by Trustee Executors, an independent corporate trustee.

Investors pay $1 per unit and redemptions are at the same price.

As at March 31, 2009 the Bonus Bonds Trust had total assets of $2.611 billion, all invested in debt securities as follows: 9 per cent issued by the New Zealand Government, 2 per cent by New Zealand Local Authorities, 67 per cent by New Zealand registered banks and the remaining 22 per cent by other corporate entities.

The effective manager of the trust is the Treasury division of ANZ National Bank and $457 million or 18.2 per cent of the fund was invested in ANZ National securities at the latest balance date.

Thus ANZ National Bank manages the trust and also has access to nearly one-fifth of its funds, albeit at commercial rates.

Investors receive no interest on their money; they only get a return if they are successful in the monthly draw. The proceeds for the draw are determined after all expenses and taxes are deducted.

At this point we need to look at the accompanying table to assess the total expenses charged against the Bonus Bonds Trust and the tax it is required to pay.

Transparency and disclosure in this area is extremely poor in New Zealand.

Essentially there are two types of fee structures:

1. A fully inclusive fee paid to the manager with the manager paying all the costs associated with the fund out of this.

2. A fee paid to the manager for its services with all additional costs paid out of the fund.

Unfortunately few funds in New Zealand have the former fee structure, most of them have the latter and this means that costs are much higher than they appear. ANZ National is paid 1.30 per cent per annum of the gross value of the fund to manage the Bonus Bonds Trust and Trustee Executors is paid 0.03 per cent to administer the trust.

In addition a number of other expenses, which are not fully disclosed, are charged against the fund. The total cost structure of Bonus Bonds Trust was $35.34 million in the March 2009 year comprising the management fee of $31.10 million, trustee fee of $0.77 million and additional costs of $3.47 million.

Thus the total expense ratio for the Bonus Bonds Trust was 1.48 per cent, an extraordinarily high figure for a fund that has most of its money invested in cash or short-term bank deposits.

A 1.48 per cent expense ratio is far more appropriate for active equity funds, which requires a great deal of research and analysis, than passive income portfolios.

Some of the additional costs that can be charged against a fund, in addition to the management fee, are as follows;

* Establishment costs, where the cost of setting up the fund is effectively charged to the investors.

* Printing, where the cost of printing the prospectuses and investment statements is charged to the fund.

* Accounting, audit and legal costs.

* Registry fees, the cost of maintaining the unit holders registry.

* Taxation advice.

* Director fees.

* Listing and meeting costs for NZX listed funds.

There is obviously a clear difference between funds that include all costs in the management fee, and the fund's total cost structure is capped at that rate, and funds that have a huge amount of additional costs.

The other major cost to the Bonus Bonds is tax, which is 30 per cent compared with 33 per cent in previous years. As a result the prizes are tax free but individuals on low tax rates are effectively charged a 30 per cent rate.

The big problem with Bonus Bonds is that the prize money shrinks when interest rates fall but the management fee continues to increase as the fund grows. In the March 2009 year the average yield on the fund was 7.1 per cent compared with 7.9 per cent in the previous period. Interest rates have dropped sharply in the current year, particularly for short-term deposits, and this is impacting on the trust's yield and prize pool.

The latest monthly prize pool was for only $6.5 million compared with $8.8 million for the same month last year and the total prize pool for the past three months was 18.3 per cent lower than the same three months in 2008.

Thus, assuming the fund is continuing to grow, then the management fee increases as the prize pool contracts. Clearly, the interests of the manager and investors are not aligned in this regard.

The management fee represented 17.3 per cent of investment income in the March 2009 year but this could be worth well over 20 per cent in the current year.

Based on the latest prize pools the post-tax return in the current year could be as low as 3 per cent, compared with 3.9 per cent in the two previous periods, while the management fee could be nearly $35 million.

There are a number of arguments both for and against Bonus Bonds. The positives are:

* It is a form of lottery with the prospect of winning $1 million in the monthly draw.

* In contrast to Lotto, investors get their money back even if they don't win.

* It is totally acceptable to have "fun investments" as a small per cent of a portfolio.

The arguments against Bonus Bonds are;

* The fee structure is too high and returns too low.

* The interests of the manager and investors are not aligned.

* There are no regular returns and investors miss out on the advantages of compounding interest.

* The tax structure is too high, particularly for individuals on a low tax rate.

But the essential issue regarding the Bonus Bonds scheme is that it is not a lottery; it is an investment product that requires a prospectus under the Securities Act 1978 but is exempt from having an investment statement.

Its transparency and disclosure is poor as the prospectus contains no detailed balance sheet information and one has to troll through the Companies Office website, which is not an easy task for uninformed investors, to get this information.

Bonus Bonds demonstrate once again that the Securities Commission should be insisting on far better prospectus disclosure. It should also establish an easy to use website with the details of all costs, particularly for those funds that don't include all costs in the management fee.

This website would clearly identify that the cost structure for Bonus Bonds is too high and a total cost structure of less than 1.00 per cent, instead of 1.48 per cent, would be more appropriate.

* Disclosure of interest; Brian Gaynor is an executive director of Milford Asset Management.