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Fair play for investors - improving fund disclosure

Disclosure in offer documents has improved immensely in recent years, but room for enhancement remains.  Some disclosure practices fail the “fair play” test and need to change.  We set out three examples of questionable disclosure in this commentary - thankfully these are found in the offer documents of only a small number of managers.

Wednesday, February 12th 2014, 9:05AM 3 Comments

by Pathfinder Asset Management

Have you ever read a 75 page prospectus and at the end wondered what it was all about?  Offer documents have historically been long, complex and impenetrable.   Sometimes that has been the fund manager’s fault, more often it has been poorly conceived legal requirements. 

The FMA’s guidance note on good disclosure marks a turning point – we now have an over-riding principle that offer documents need to be “clear, concise and effective”.  We also have a new offer regime on its way with a “product disclosure statement” (or “PDS”) replacing the investment statement and prospectus.  The new regime will have a 2 year transition period meaning current disclosure documents will be with us for some time yet. 

Despite notable disclosure improvements in recent years, some bad practices still slip through the cracks.  Below we list three we have seen in current offer documents which fail the test of fair play.  The use of these practices is not widespread (we are talking a small number of managers), but they just shouldn’t be happening at all.


1. Disclosure around fund set up costs
It is little known that fund managers often recover fund start-up costs of a fund from investors. This is like establishing a new business and charging an extra levy to customers for a good chunk of the start-up costs.  In the case of the funds industry the costs can be significant (particularly for the first issue by a manager).  Costs come from not just preparing a prospectus but also from detailed tax advice, reviews by the trustee’s lawyers, printing of investment statements and plenty of other hidden charges that in total can approach $200,000.
Charging these costs back to the fund can heavily disadvantage the first investors who buy units.  If the fund is small (which is often the case with new funds)  then the charge will have a material impact on fees.  Charging set up costs should not necessarily be outlawed – but it should be fully disclosed.

Take this recent example - a fund set up in 2011 charged set up costs back to the fund of over $150,000.  This added 1% to total fees in the first year which is significant given that the manager’s base fee is 1.5%.  The charge back and impact on investors was not well disclosed – it is safe to say that none of the investors are likely to have realised that by joining the fund in its first year they were hit with a 1% set up levy on top of the 1.5% base management fee.

So what is the solution here?  If set up costs are to be charged then managers should explain the formation costs, the fact these are charged back and the possible impact on investor returns.  A better solution is one that many managers now follow – just charge a fixed or capped fee each year and if costs exceed that number then that is the manager’s problem.  With a capped or fixed fee investors know exactly what they are paying in fees every year.


2. Explaining management fees
Disclosure of management fees has always been a quagmire.  Should the fee amount disclosed just cover the manager base fee?  What about management costs like administration, registry, performance fees and brokerage?  And for fund of fund structures, what about fees charged in underlying layers of the structure?  These matters are being addressed by the industry and regulator to ensure investors can understand the total fee burden. 

But one part of the disclosure puzzle that seems to occasionally slip through is providing fee information based on a monthly charge.  Investors expect and understand an annual charge – for example one prospectus says:

“The management fee payable to the Manager is 1.25% per annum.”

Investors should grasp that this means for every $100 invested an annual charge of $1.25 goes to the manager.  But what about another prospectus that says the manager is paid:

“a management fee equal to 0.042% per month of NAV of the Units”. 

Of course 0.042% sounds very cheap – but investors are unlikely to grasp that this is a monthly charge which equates to 0.50% per annum.  The point is not whether 0.50% per annum is or is not a fair fee, the point is that investors will be thinking the fee is a minuscule 0.042% when it is really 12 times that number.  This form of disclosure should not be allowed.


3. Examples used should be realistic
Performance fees are a particularly contentious area.  What is a fair performance hurdle?  Should the fee calculation have a high tide mark?  Should it ever reset?  A small (but important) disclosure point arises when managers try and explain performance fee calculations by using unrealistic examples. 

In a recently registered prospectus the manager says:

“a performance fee of 15% charged on the performance margin over RBNZ Official Cash Rate plus 6% per annum (i.e., if the RBNZ OCR rate was 5% then the performance fee would be earned on the margin over 11%).” 

So according to the manager the performance fee is paid if the fund earns a return over 11%?  Wrong – that example uses an OCR of 5%, the real OCR is in fact 2.5%.  Is that just a slip of the pen or accidentally forgetting to update numbers in a previous prospectus? The last time the OCR was 5% was in December 2008 – over 5 years ago.  The real performance fee hurdle for this fund is 8.5% not 11%. 

Another manager works through performance fee examples. A table shows that if the fund return is 10% no performance fee is payable while a performance fee is payable for returns of 15% and above.  But the introduction to the table says:

“the example assumes an average OCR of 5% for the Managed Funds….” 

Again, investors are unlikely to grasp that in the real world on the current OCR a performance fee is payable from a 7.5% (not 10%) fund return - the worked examples understate the fee.  Are these sorts of examples fair to investors?

4. Concluding thoughts
Good disclosure is critical for investors to have confidence in our capital markets and fund management industry.  It will also help ensure that the actual investment experience matches the investor’s expectations from the product described to them.  Describing fees, risks or product features in a way that is confusing or incomplete doesn’t help investors or the industry.

A simple way of approaching disclosure is to ask two questions:

  1. Has all information relevant to an investment decision been included?
  2. Does the way it is disclosed mean investors are likely to understand it?

It’s not just what is disclosed, it is also the way it is disclosed.  The answer to getting this right is not just more or better regulation.  We can regulate offer document disclosure standards all we like – but ultimately it comes down to common sense judgement and fair play standards by managers and their lawyers.


John Berry
Executive Director
Pathfinder Asset Management Limited


Pathfinder is a fund manager and does not give financial advice. Seek professional investment and tax advice before making investment decisions.

Pathfinder is an independent boutique fund manager based in Auckland. We value transparency, social responsibility and aligning interests with our investors. We are also advocates of reducing the complexity of investment products for NZ investors. www.pfam.co.nz

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Comments from our readers

On 12 February 2014 at 10:29 am Ally said:
Performance fees are the real grey area. One prominent fund with $200 million under management charges a 1% p.a. management fee, then this on top:

"10% of the gain in value of units over the value of the NZX 90 day Bank Bill Index (adjusted for tax)"

So currently that is a hurdle of about 2% p.a. How advisors can recommend such an arrangement as being "in the client's best interests" is beyond me.

On 12 February 2014 at 11:19 am John Berry said:
Ally - I agree with you that a cash benchmark is totally inappropriate as a performance hurdle for an equity fund. But from a disclosure perspective if it is properly highlighted for investors in the offer docs then its out there for advisers to decide if they want to put clients into the fund. Good disclosure of course doesn't make the practice appropriate or fair to investors .....
On 12 February 2014 at 5:15 pm John Milner said:
All well written and responded to John Berry. And you're so right about good disclosure not always being fair to clients.

I personally avoid any manager who expects being rewarded with a performance fee.

Surely this provides the manager with an incentive to take more risk than the average investor cannot budget for?

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