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Fund managers under fire

By Nick Stride

Friday 15th August 2003

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Another quarter, another big outflow of investors' money from the funds management industry.

After three years of falling world equities markets, funds management ­ once one of the surest moneymakers on the planet­ is under unprecedented pressure.

Around the world investors have been pulling their money out of managed funds, leaving managers battling to cut costs as their fees shrink.

In the June quarter, according to researcher FundSource, the $18 billion New Zealand industry suffered a $15 million net outflow. That was at least an improvement on the $250 million lost in the first three months of the year but it was boosted by a $277 million flow into mortgage trusts.

Over the last year the industry has lost $656 million of funds under management. On top of that there has been a massive erosion of the value of funds under management due to falling share prices.

The loss of fee income is bad enough. Hard questions are being asked at the big four Australian banks ­ Westpac with BT, Commonwealth Bank with Colonial, ANZ with ING, and National Australia Bank with MLC ­ which paid high multiples to get into the "wealth management" game over the past 10 years.

None of this is new. Investors habitually pile in while markets are rising and sell out when they fall, often taking big losses in the process.

But this time around the hurt has been too bad for investors to accept that the markets ­ that is, themselves ­ are wholly to blame.

Like the audit profession, company boards and managers and investment bankers, the industry itself is under attack.

The charge sheet is a long one. Underperformance, excessive and undisclosed fees and charges, lavish lifestyles, overselling of inappropriate products, negligence on corporate governance, dubious relationships with researchers and stockbrokers ­ the list goes on.

In the US, regulators have been taking an interest and new laws have been passed. A London thinktank is warning the industry will go into "terminal decline" unless it changes its ways.

"The truth is," the Economist wrote in an editorial last month, "that for the most part fund managers have offered extremely poor value for money. Their records of outperformance are almost always followed by stretches of underperformance.

"Over long periods of time hardly any fund managers have beaten the market averages. And all the while they charge their clients big fees for the privilege of losing their money."

Like the Economist and poacher-turned-gamekeeper US critic John Bogle, London think-tank Create has concluded investors would be better off entrusting their cash to passive managers who simply track a market index and charge far less than "active" managers, many of whom are in fact "closet" index trackers.

Managers respond with the "relative returns" argument. During the past three years, over which the MSCI world index has lost 35.5%, the value of units in AMP's International Shares Trust, for instance, has fallen only 16.7%.

But that is of little comfort to investors who have had to pay the managers' fees all along.

Managers also tend to insist investors should "hang in there" when markets fall, arguing shares outperform other investment asset classes over long periods of time.

That argument doesn't impress New Zealand Shareholders' Association chairman Bruce Sheppard.

"If you accept the historic statistics that, on average, sharemarkets globally rise on a pre-tax basis of 9% per annum, it makes it very hard to justify elaborate financial structures for investment," he recently wrote to investment clients.

When a financial planner takes 1%, a custodial agent another 0.5% and a fund manager another 1-3%, what is left is small enough to make bank term deposits look attractive.

"Ignore comments from fund managers to 'hang in there,'" Mr Sheppard said. "If anything is to be hanged, hang the manager."

Managers have rushed out an array of capital-guaranteed products that will at least address the problem investors have with paying somebody to lose their money, but such products by their nature will never outperform rising markets over time.

Disillusionment with traditional managers has driven the rapid proliferation of a new competitor, the absolute return manager or "hedge fund."

Hedge funds charge investors a much smaller fee than traditional managers and get the rest of their returns by charging 20-25% of the profits they make.

Because they use leverage, short-selling and derivatives, they are not without risk. Hedge fund collapses in the US include Long Term Capital Management, George Soros' Quantum Fund, Boston-based Beacon Hill, and New York-based Lancer Partners.

But they have taken off among retail investors in Australia. A first report there by researcher Van Eyk, on the performance of 11 hedge funds, found in the three years to March they had generated an average return of 21%, co mpared with the ASX200 index's 0.9%.

Over the last year, when global equities were deep in the red, the funds made 5.5% and the top manager made 29.8%.

Investor cynicism is also fed by the high salaries commanded by supposedly highly sophisticated professional investors.

Fund managers tend to keep their individual share dealings as private as possible but substantial security holder disclosures occasionally paint an unflattering picture.

When Sir Michael Fay, David Richwhite and other major investors in Tranz Rail sold out early last year at about $3.70, the majority of their shares were bought by institutions. Following the sellout the top six holders had 43% between them.

In the steep share price falls that quickly followed they made huge losses for their investors, realised or unrealised.

One of the institutions concerned was Axa Asia Pacific, which went on a few months later to take a major position in plastics maker Vertex, just before the share price collapsed on the first of two profit warnings.

Behind closed doors fund managers have a tendency to scorn research from "sell-side" sharebroking analysts, saying they do their own research and make their own company visits.

Yet, analysts say, they are quick to blame sharebrokers when their picks go wrong. Some have also been known to pressure analysts who downgrade or put out "sell" recommendations on companies in which the funds have a big position.

Managers are also under fire for taking too lethargic an attitude to enforcing high corporate governance standards at the companies they invest in.

In the US a law was passed last year requiring them to say how they voted their shares. In the UK proposed regulation will impose financial penalties or loss of dividends on those who hold shares on behalf of others and fail to vote them.

Closer to home institutional investors have long been criticised for failing to attend shareholders meetings and for handing their voting proxies en masse to company chairmen.

ANZ Bank's Joseph Healy has suggested as possible reasons "a culture that seeks to avoid conflict," an unwillingness to challenge company management and the conflicts of interest that can arise when institutions do other business with investee companies.

The Shareholders' Association recently took state-controlled fund manager ACC to task for failing to vote its CDL stake. The manager blamed its failure on "an oversight."

Arguably the most serious charge laid against fund managers has been their practice of boosting funds under management, and therefore fee income, by selling heavily to investors whichever asset class or market happens to be in vogue.

"They encourage investors," the Economist thundered, "rather than spread their risks wisely or seek the best match for their future liabilities, to put their money into the most modish assets going, often just when they become overvalued ­ whether tech stocks and dotcoms in the late 1990s or, now, corporate bonds, hedge funds and private equity funds."

Some have been victims of their own drive for investment dollars. AMP's recent humbling was due in large part to overselling of equity-backed, guaranteed-return products in its UK operations.

Similar problems underlay Royal & SunAlliance's need to raise capital by floating Promina.

Such poor judgments, falling fee income and the threat of regulation are likely to see parent companies exerting far tighter control over their fund management subsidiaries in the future.

The fund manager's long lunch may at long last be over.

Investors would be better off entrusting their cash to passive managers who simply track a market index and charge far less than 'active' managers, many of whom are in fact 'closet' index trackers

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