Brent Sheather: Financial Markets Conduct Act - still a work in progress

Photo / iStock

Brent Sheather is an Authorised Financial Adviser and a personal finance and investments writer.

The investment police at the Financial Markets Authority (FMA) finished 2015 in something of a flurry producing a number of reports which will fundamentally influence the way NZ'ers invest and their outcomes in the future.

In October the FMA produced a document entitled "Draft Guidance On Disclosure Of Certain Fees & Returns By Managed Funds" and followed up with "Sales and Advice" in November.

Probably the key element of the October report was the FMA's determination as to what fund managers disclosure obligations were as regards fees generally and performance fees in particular. First off some background on performance fees.

Most local fund managers, not content with appropriating just 20 per cent of retail investors prospective equity returns, have in recent years decided that their needs would be more aligned with those of their retail clients if they received a performance bonus as well, amounting to between 10-15 per cent of "excess" returns.

Unfortunately being clever fellows many of the local masters of the universe have determined that "excess" returns are calculated by reference to an easy to beat fixed interest benchmark, typically 90 day bill rates plus a margin.

Thus performance is something of a misnomer - despite describing these fees as performance fees most local manifestations of the performance fee rort are not calculated with reference to an outperformance of the relevant stock market.

To understand how this nuance works against retail investors consider that 90 day bill rates are currently around 2.6 per cent and the stock market is priced to return an average of 8-10 per cent pa although frequently returns 20 per cent or more in more year followed by a down year or two.

Speaking generally however it is common practice for institutional investors to pay fees based on assets under management, not performance, for long-only equities mandates.

No surprises that this sort of blatantly mis-specified performance fee is illegal in many more civilized countries.

For further perspective on the suitability of performance fees generally let alone patently unfair ones a spokeswoman for the NZ Super Fund, in a recent email, said "speaking generally however it is common practice for institutional investors to pay fees based on assets under management, not performance, for long-only equities mandates". Performance fees however aren't all bad - it's probably fair to say that many investors see them as the last straw as regards active management and it has thus hastened the stampede into low cost, passive products.

The FMA are rightly concerned with the local performance fee rort but in the absence of intelligent decision making by the authors of the Financial Markets Conduct Act have had to rely on disclosure to protect consumers despite the fact that there is a lot of research showing that disclosure doesn't work particularly well.

Incidentally the FMC Act has been trumpeted as creating a new environment for retail investors, one where they can trust that their interests are being put first, however the same old rorts are still available to fund managers in respect of performance fees like no high water mark and inappropriate benchmarks in the calculation thereof.

The question must be asked as to who were the bright sparks that put the FMC Act together?

One can only conclude that either they didn't understand the business they were regulating or that they were ex fund managers or both. A bit embarrassing for the FMA that they are left to clean up the mess.

In the report the FMA advises that "managers of KiwiSaver schemes must ensure any performance based fees are reasonable. We encourage non KiwiSaver schemes to also take note of this guidance. We are particularly concerned about the fact that performance based fees are being linked to an inappropriate benchmark."

Reading between the lines then it is pretty obvious that the performance fees for non KiwiSaver managed funds are permitted under the law to be unreasonable or in other words unfair.

The FMA state that irrespective of the performance fee arrangement all managed funds must report their performance against the returns of an appropriate benchmark index and they write "although it is not a legal requirement it is reasonable to link the hurdle rate for any performance fee to the returns of this market index".

This is a commercial matter and should not form part of the FMA's regulatory guidance. Provided the hurdle rate is identified and where it differs from the appropriate market benchmark is clearly disclosed that should be the end of the matter.

However the silly FMC act doesn't compel fund managers to do this thus the FMA requires fund managers who don't do this (most of them) to disclose this fact.

At this stage a cynic might take the view that the FMA's vision as elucidated on its website needs editing. The website says "our main vision is to promote and facilitate the development of fair, efficient and transparent financial markets".

In light of the performance fee determinations perhaps the following words should be added at the end of the vision statement "most of time".

In light of this poor legislation these are admirable moves from the FMA not least because, as recent events in the UK have demonstrated, financial regulators cannot always rely on the support of government if they try to institute meaningful changes that benefit retail consumers at the expense of big finance.

Given that so many Members of Parliament have a background in big finance regulator's jobs are probably even more fraught locally.

What is almost as interesting as the FMA's original papers are the submissions from industry, also known as lobbying.

After a couple of months of waiting I managed to get the submissions on the Draft Guidance paper. Predictably most industry participants, especially those charging unfair performance fees, weren't happy. However one of the more interesting submissions on performance fees came from David Ireland of Kensington Swan. Mr Ireland took exception to the FMA's proposed description of unfair performance fees as being "inappropriate".

He wrote "this is a commercial matter and should not form part of the FMA's regulatory guidance. Provided the hurdle rate is identified and where it differs from the appropriate market benchmark is clearly disclosed that should be the end of the matter".

This is extraordinary stuff from Mr Ireland because Mr Ireland is chairman of the Code Committee for financial advisors. A key feature of the Code of Conduct is detailed in Code Standard 1 which says that financial advisors must put their client's interest first.

If performance fees with appropriate benchmarks aren't viewed as attractive by the likes of the NZ Super Fund then performance fees with inappropriate benchmarks almost certainly should not be inflicted on retail investors. Therefore financial advisors who are required to put client's interest first should not be recommending funds with unfair performance fees. In his job at the Code Committee he is batting for retail investors but in his submission to the FMA on performance fees he appears to be reciting the same arguments as used by fund managers. Hmmm.

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