Brent Sheather: Tough task to track managed funds

One of the big problems with investing for retirement through managed funds is the lack of genuinely independent research.

Even honest analysis is problematic - a fundamental flaw with rating managed funds is the tendency to focus on shorter term performance despite the fact that equities exhibit serial negative correlation (good years are followed by bad) and, with a few notable exceptions, fund manager outperformance doesn't persist.

Overseas a number of the big UK stockbrokers who used to cover the investment trust sector have withdrawn from that business and locally almost no one takes the various fund manager of the year awards seriously.

In fact there seem to have been so many incarnations of such awards that just about every fund manager gets to win one sooner or later with most of the winners having uninspiring longer-term performance and uniformly high fees.

In many cases what research there is is often in some way funded by the manager of the product being researched, with obvious implications for credibility. As we now know this was the case overseas with collateralised debt obligations, which were assessed by the rating agencies for a fee, with disastrous results.

The local industry's attempts at rating finance company debentures turned out to be a total waste of time.

So with little to go on, where does that leave the retail investor? You might think that because a financial planning group has a particular managed fund on its platform, that this is because of the attractiveness of the product. After all, that is what the brochures say.

Vestar used to labour the point - its investment committee apparently toiled into the wee hours to come up with gems like Cymbis Finance Enhanced Debenture Stock, Clendon Shopping Centre Preference Shares and the Ascot Private Equity Investment Fund, all of which have turned out rather badly for investors.

There may be other factors influencing decisions: in Australia the regulatory authorities have highlighted the fact that secret deals are often done whereby a product only goes on the platform if the manager promises to pay higher than normal fees to the platform provider.

Platinum Management investment legend Kerr Neilson has been very critical of this practice. Platinum has a great long-term record and presumably doesn't feel the need to split its management fee with financial advisory groups.

Locally one reason for the absurd popularity of the worst finance companies was that they apparently had "arrangements" with some advisers to get extra commission.

All things considered it's not a good look for the industry and, with Morningstar's recent derisory comments, an observant retail investor might conclude that a sensible savings strategy would be to treat a "highly recommended" investment product like someone with a dose of the swine flu. There are lots of precedents for such a strategy. In the UK a notable piece of independent research has just been produced for the Department of Work and Pension by Professor David McCarthy of the Tanaka Business School.

His paper looks at so-called structured products which give you exposure to a risky asset class - like for example, shares - with a capital guarantee.

These are usually five-year guaranteed bonds and in the UK they are sold by financial planners and the banks. They promise the higher return of shares without the risk.

As with most things that sound too good to be true, so are guaranteed products, according to the Department of Work and Pension-commissioned independent research. More about that later.

But the funny thing is that at the same time that the Work and Pension research critical of guaranteed products was being published, a survey of UK financial planners revealed that these same products are their most popular investment, followed by managed funds and corporate bonds.

The Financial Times reports that more than 90 per cent of the 130 independent financial advisers in the survey said they recommended guaranteed products. Hmmm.

In this country, thankfully, guaranteed products don't seem to be as popular. But they are apparently top of the list of things sold to very high net worth individuals overseas.

In an interview with the FT, Professor McCarthy commented that the disclosure of information on the investment costs of guaranteed products was most unsatisfactory. It appears to be the same here.

The website of one provider discloses a very high 3 per cent initial brokerage charge (surprise, surprise) and a 2 per cent exit fee but, unbelievably, states that there are no management fees. A good rule of thumb is that whenever you are told that there are no management fees on a product, you should expect reality to be at least twice the average level.

In the case of guaranteed funds, the "no fees" claim is technically correct but, in practice, misleading, because normally fund managers of guaranteed products are remunerated by taking all the dividend income on the portfolio of stocks owned.

Of course, this isn't disclosed, but it is usually what happens and, as we know from this column's recent review of the 2009 Global Investment Returns Yearbook, dividends for share investors are very important. The average yield on the world stockmarket is currently about 3 per cent, which amounts to a pretty hefty annual fee, even if it is not called such.

The significance of dividends was illustrated in the book, in which the London Business School professors estimated that, on the basis of normal equity returns, there is a 50:50 chance that the US stockmarket would recover by 2017. However, if you excluded dividends, it would take five years longer to get your money back.

Now back to Professor McCarthy's report. It is a hefty 14 megabytes, most of it highly technical stuff, but the conclusions are pretty straightforward: he reckons that actual annual expenses including the cost of the guarantee average about 15 per cent to 20 per cent of the capital invested.

That's 3 to 4 per cent a year over five years and about twice the typical management expense ratio.

Accordingly, Professor McCarthy concludes, given there are less costly alternatives, there should be zero demand for these sort of products and, if investors wanted low risk, they should buy low-risk assets like government bonds.

This is the same conclusion that Dimson, Marsh and Staunton, the London Business School trio of economists, came to in the 2008 year book. They concluded that it is relatively expensive to engineer a protected portfolio.

The fees embedded by the intermediary creating the structured product are much larger than the fees normally charged for managing an index fund.

The main reasons returns from a protected portfolio are so poor (protection from anything greater than a 1 per cent decline annually reduces average returns from 9.77 per cent a year to just 0.4 per cent a year) is that it is very expensive to buy protection against severe financial setbacks.

Nobody likes a Black Monday and no one knows when it's going to happen so the price to buy protection from it is prohibitive - more expensive, in fact, in terms of derivative prices than is even implied by actual volatility.

The business school trio found that for any given level of risk from a protected portfolio, returns are higher for the same level of risk from a portfolio split between shares and low-risk bonds.

If you are worried that the stock market is expensive and likely to crash, they suggest low-risk government bonds. But of course they don't pay a 3 per cent fee.

* Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.