If you’re investing in a managed fund, how do you know whether you are receiving value for money? How do you know whether the manager is giving you the benefit of his or her skills? And how do you know whether the manager is using an appropriate benchmark? A new report highlights some of the potential blind spots for active fund investors.
Despite study after study highlighting the zero-sum game that is active fund management, a lot of people continue to make a fortune selling to investors the idea that they can consistently outperform the market through astute stock selection and tactical asset allocation.
And insofar as managers do possess demonstrable skill in consistently beating the market, the evidence suggests they either capture the rents associated with that skill through their fees or erode the returns through additional costs of active management.
What’s more, managers’ skill is often hard to discern when their chosen performance benchmarks are inappropriate for the risk inherent in the strategies they offer.
A recent report by the New Zealand market regulator only adds to this case, finding that the benefits to investors of managers’ skill is reduced by the additional fees charged and the costs of commission paid by the managers to so-called financial “advisers”. Using poor benchmarks makes it even harder to sort skill from luck.
Reporting on the outcomes of a pilot study to determine whether fund managers were implementing value-for-money guidance, the Financial Markets Authority (FMA) did find what it called “genuine, repeatable competence” among managers.
“The drag of fees, however, reduced the benefit of this competence to investors in some funds,” the FMA report added. “Fee levels were substantially driven by costs paid to external parties, such as trail commissions to financial advisers and other third parties, and performance fees to underlying investment managers.”
Worse, the report found very few instances were fund members were actually told that they fees they were paying were inflated by the costs of these commissions. In other words, funds were essentially using commissions to effectively “buy” investors rather than competing for members based on their supposed value proposition.
The industry’s response, and one the FMA report is sympathetic to, is that advice is valuable. But New Zealand’s voluntary retirement savings scheme, ‘KiwiSaver’, is still maturing. That means balances are lower than for managed funds and even a moderate, optional fee for advice may dissuade members from using it.
The big question, as was debated in Australia and the UK for years, is whether financial “advice” supported by trail commission payments from fund managers distributing product can legitimately be described as such.
In the New Zealand case, the FMA report found while it is still common for managers to pay substantial sums in initial and/or ongoing trail commissions to third parties to acquire members, the members’ interaction with the adviser rarely involves ongoing advice. In other words, the “advice” is most often purely transactional — a product sale.
The FMA describes as “nonsense” claims by managers that they, not members, meet the cost of trail commissions because it is paid for from management fee revenue.
“The management fee is paid by the member and has been sized by the manager to, in part, enable the payment of ongoing trail commissions. Members pay the cost of trail commissions,” the report says.
Aside from any demonstrated skill being eaten up by fees and costs, the regulator also found some managers were using an inappropriate market index to benchmark their performance and justify the additional fees being charged. For example, some were using cash-based benchmarks for equity or fixed income exposure.
“If a fund manager is not using an appropriate market index, how do they or their investors know what their strategy is, or if it provides value for the risk investors are taking and the cost they are paying?” said FMA director of investment management Paul Gregory.
“We are keen to understand the basis for fund manager scepticism about the relevance of an appropriate market index to value for money. An appropriate market index is not — and is not supposed to be — easy to match or beat for passive and active fund managers, respectively.”
The FMA report was based on a voluntary pilot study involving 14 funds, including a combination of KiwiSaver and non-KiwiSaver funds, active and passive funds, bank and non-bank funds, long-only funds, funds with and without performance fees, and funds with varying approaches to offering, charging for, and disclosing the cost of advice.
The FMA is now consulting with the industry on the commission and market index issues raised in the pilot study and says it has “other regulator tools” available if it finds persistent conduct issues arising.
A value-for-money review of the entire industry is due to by the end of May 2023. In the meantime, active investors should pay close attention to the costs they're occurring and the value they're receiving in return.
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