INVESTMENT COMMENTARY

The next regulatory rounds

As NZ plays regulatory catch-up with other developed world countries David van Schaardenburg looks at further alterations which could meet and even exceed the investor experience overseas.

BY DAVID VAN SCHAARDENBURG

Pronouncements over the last 12 months from the Financial Markets Authority (FMA) have more often than not been focused on the new financial adviser rules. But the increased allocation of their resources dedicated to the oversight of investment management entities hints at likely new rounds of regulations relevant to the activities of New Zealand based professional investors.

Where might the FMA’s next investment focus be

While New Zealand and New Zealand based investors became full participants in global capital markets in the mid- 1980s, oversight and regulation of New Zealand’s professional investors and financial advisers has notably lagged other developed world economies.

Hence the regulatory catch up that has been occurring since the Securities Commission morphed into the FMA a decade ago. An example of a huge leap forward (“catch-up”) in the last decade has been the Financial Markets Conduct Act which amongst numerous positive (for investors and their advisers) new rules have been:

• fuller and consistent disclosure of fund fees

• standardisation of disclosure of key fee, return and portfolio structure information.

However, for the benefit of their investors, in my opinion there are still a number of important areas where New Zealand based funds management firms and their funds require further or altered regulation – in part to catch up with the investor experience in other developed economies but in some instances to maybe improve on them.

Fund returns advertising and promotion

What does the past tell us about the future? In my career in funds management, past returns have been both equally useful and misleading as to the merits of a fund or its fund manager. This problem is exacerbated when looking at fund returns over short-term time frames.

Frankly, when does a fund manager advertise the merits of a fund when they’ve done poorly? Never. So we know from the start that any fund return advertising is going to be selective in terms of either or both the investment time frame or the fund chosen. If you manage 20 funds there is bound to be several that have done well over some time frame.

In their latest KiwiSaver report (March 2021), Morningstar agree with the need to use longer-term time frames in fund assessment:

“It is most appropriate to evaluate performance of a KiwiSaver scheme by studying its long-term returns. Over

10 years, the …” By this statement it’s not unreasonable to presume that Morningstar believe a 10 year plus track record is more valuable in fund assessment than shorter-term periods. While not noted in Morningstar’s report, given KiwiSaver investors most often have multi decade investing timeframes, knowing what are the longterm return implications of each fund category is in most circumstances one of the most important decision inputs a KiwiSaver investor can have.

For example, over the 10 years to March 2021, the average KiwiSaver growth fund has returned a 157% cumulative return post fees pre-tax (annualised fund returns ranging from 8.1 to 10.7% excluding one outlier) versus a conservative fund average of 75% cumulative return (annualised fund returns ranged 5.4 to 6.8%).

My recommendation – promotion of fund returns should be over at least a five year period with two additional data points – what the fund’s market benchmark returned over that same period and what the previous five year fund versus benchmark returns were.

The DIMS anomaly

Over the last decade anecdotally the funds invested via discretionary investment management services (DIMS) has grown enormously.

While there is not official data of the quantum of funds advised under DIMS,

'My recommendation – cap the financial incentive that can be created from performance fees in retail funds to remove the risk of moral hazard and potential for undue portfolio risk'

I understand that near $100 billion is now invested via DIMS. This makes this sector by asset size larger than the KiwiSaver industry ($80 billion) and retail unit trusts ($42 billion) the latter having not grown in aggregate funds under management in the two years to December 2020 (source: Reserve Bank).

The traditional large brokerage firms have led the DIMS growth charge but many smaller investment advisory firms are also DIMS providers. The attraction for advisers to use DIMS is in their flexibility both investment, client relationship and fee wise and the lesser level of cost disclosure versus managed funds. In essence DIMS cuts out the retail fund manager.

Much work has occurred in the last five years to improve and standardise the disclosures made in the offering documents and regular client communications made by KiwiSaver and unit trust providers.

As a trustee of two different trusts who each have used two differing large scale DIMS providers, the relative reduction, non-standardisation, extra complexity and reduced clarity of fee and return reporting under DIMS is noticeable. Including that they are not required to fully disclose in $ or % terms all the revenues they actually earn from the client account.

My KiwiSaver/unit trust provider must give me one percentage number as to what they think they will charge in totality before I invest and then annually report one percentage number as to what they did charge.

Given the size and growth rate of investor funds via DIMS, client disclosure levels need to markedly improve.

My recommendation – standardisation of reporting of all revenues a DIMS provider may get from a client … before and after they invest … expressed in simple terms as one number.

Performance fees

The history of performance fees in New Zealand retail funds over the last 10 years has been chequered. The odds have tended to favour the manager through either easy to beat benchmarks, or through taking additional risks (high frequency trading, security price manipulation, leverage, speculative investing, lack of security diversification) which if they work mean the fund manager earns a bonus for the extra risks taken but if not, the client, typically a retiree or near retiree suffers the burn from a poor decision.

A dimensional study referred to funds management performance fees as resembling a call option – the manager gets paid a portion of the investor’s profits on the upside but do not generally share in the down side. So when millions of dollars are at stake it’s hard for performance fees NOT to create a moral hazard for the 30 something portfolio manager.

My recommendation – cap the financial incentive that can be created from performance fees in retail funds to remove the risk of moral hazard and potential for undue portfolio risk.

Investment security restrictions

In other markets the range of investments that can be legally made by retail funds is more restrictive than in New Zealand. This is in part due to their standard daily liquidity requirements.

For example, US mutual funds can’t borrow money nor can they invest in illiquid investments which tends to rule out such funds investing directly into property or more exotic investments. These restrictions were put in place in the aftermath of the 1929 crash but still have their merits today in ensuring retail fund managers ensure their portfolios are liquid … in all market environments.

With ESG investment considerations becoming more important, requiring retail funds to invest “morally” could become the standard. So no investment by such funds in companies which are involved in nuclear weapons, cluster bombs, slavery, or excessive environmental damage. The latter might include blockchain currencies like Bitcoin given the electric power consumption required to harvest them.

My recommendation – make a basic ESG requirement for security selection mandatory for all retail funds.

Following my last column titled “A bond is broken” just how much of a problem low long-term future returns from cash and bonds has been and will be in the future for New Zealand investors was highlighted in the recent Morningstar report with:

- the average KiwiSaver allocation of 43.9% ($35 billion) to such assets. This large defensive allocation makes no sense given the multi decade investment timeframe of most KiwiSaver members

- the average return over the last 10 years from KiwiSaver growth funds of 9.9% versus only 5.8% for conservative funds.

This unduly high allocation to low return assets by long-term investors (KiwiSaver members) in my opinion reflects a collective failure by financial advisers and KiwiSaver managers to better educate their clients to make more rational long-term investment decisions. A

David van Schaardenburg is an independent investment analyst.