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Managed funds: changes advisers need to know

In this month’s Pathfinder Commentary John Berry looks at regulatory changes to managed funds and what this means for investors and advisers.  In particular how will fee disclosures, offer documents and governance structures change?

Thursday, July 10th 2014, 4:10PM

by Pathfinder Asset Management

A third round of consultation on the Financial Markets Conduct Act regulations has just concluded.  Although not yet final, the new regulatory structure is taking shape.  The Regulations impact on the offer of equities, debt securities, derivatives, managed funds, DIMS and “other managed investment schemes” (such as property proportionate ownership schemes).  In this commentary we focus on key changes for managed funds.

What is a managed fund?
A managed fund is an open ended unit trust where assets are pooled for investors.  To fall in the managed fund regulatory category the underlying assets must be liquid - 80% of assets must be either (a) capable of being sold at market value within 10 days or (b) bank deposits.  A property unit trust will not fall in this category because of its illiquid land and building assets.

Quick overview

We look below at 4 key parts of the new regulations:

  • Offer documents (PDS)
  • Online register of offers
  • Quarterly reporting requirements
  • Governance

New offer document - Product Disclosure Statement
The prospectus and investment statement are replaced by a single (and simpler) offer document called a Product Disclosure Statement (PDS).  This follows a very prescribed form and defined content – including the most important information in an up-front Key Information Section.  The intention is to allow comparisons on a “like for like” basis between investment products.

Two moves are intended to dramatically change the culture of offer document presentation –

  • A strict word limit will make sure the PDS stays concise (the FMA regard this as a key “circuit breaker” to stop the current practice of long documents).
  • The FMA is encouraging a shift from a lawyer driven (i.e. risk mitigation) document preparation to a management driven process (i.e. a more investor-centric approach).  The intention is to change the “if in doubt, include it” culture.  Offer documents will become shorter and more readable for advisers.

PDS documents are intended to have a relatively long life, in fact they will have no expiry date.  This is achieved by the PDS containing largely “static” data such as product structure and features.  Unlike the current prospectus requirements, a PDS will have little in the way of “dynamic” information that would require constant updating (such as investment holdings and returns which will instead be covered by quarterly reporting).

Risk indicator
The PDS includes a risk indicator based on the UCITS (European) framework with a scale of 1 (lowest risk) to 7 (highest risk).  Risk indicators are notoriously difficult to construct – the NZ version will be based on the standard deviation of weekly returns for the last 5 years. 
This is of course backward looking and does not recognise that some investments can be low volatility for a long period and then be found essentially worthless overnight (i.e. Long Term Capital Management, Credit Sails and Basis Capital).  This move from low volatility to catastrophe is not quite captured by the required risk warning – “while risk indicators are usually relatively stable, they do shift from time to time”.  Introducing a risk measure is noble but fraught with difficulties.

Here’s one difficulty - 5 years of return data must be used for the risk indicator but not all funds have been around for 5 years.  If a fund’s history is shorter then the remainder must be backtested (for those not familiar with “backtesting”, this is an invitation to essentially make up your return history).  For funds that involve some decision making (not index or rules based), you will never see bad backtested data as this is investing with the benefit of hindsight…..

On-line “register of offers of financial products”
Managed funds will be loaded on an online register which will include:

  • Return information
  • Fee structures which for fund of funds will require drilling through fee layers to show a total fee burden (good information for advisers)
  • PIE chart of target and actual investment mixes
  • Investment holdings list
  • Key personnel
  • Simple financial ratios for liquidity and debt

The register will also contain more detailed background information like the Statement of Investment Policies and Objectives (SIPO).  Currently every fund offered to the market should have a SIPO defining the investment objective and parameters but these are typically not made public – in fact I would be surprised if most advisers have ever seen a SIPO.  The new Regulations will change that.

There will be no charge for investors and advisers to search the register – costs are met by issuers.  Offers of Australian Unit Trusts made under the mutual recognition rules will be included in the register however for some obscure reason Australian issuers are exempt from the new fees that will apply to NZ issuers (is that a level playing field…?).

Quarterly reporting
New reporting rules have been broadly modelled on the Kiwisaver requirements.

Returns must be benchmarked to a hypothetical fund (with no fees) that invests in a broad based securities index.  This benchmark should be an appropriate measure of the fund’s assets – but does not have to be the same as the benchmark used for performance fee calculations.  Equity funds can continue to use cash benchmarks – and there is no requirement to explain to investors that a performance fee can still be payable even if the fund does not beat returns of the hypothetical fund benchmark.  This is confusing.

Returns must be stated after PIE tax.  If the object of the new offer regime is to improve the comparability of investments, after tax PIE returns are unhelpful.  How can managed funds sensibly be compared to returns of all other assets which are thought of in pre-tax returns:

  • Bank deposits
  • Residential rental property yields
  • Corporate bond yields
  • Australian unit trust and ETF yields

How can you compare the return on a bank deposit (pre-tax) with a cash PIE offered by the same institution (post-tax)? The comparison will mislead investors.  Another issue is that post tax reporting must be made only at the 28% PIR.  This will confuse investors on 0%, 10.5% and 17.5% PIRs.

Fund managers will need to apply for a license and prove their processes and governance are fit for purpose. 

A statutory duty of care is introduced for fund managers – a requirement to exercise the care and skill of a prudent professional.  There is also a duty on managers to act in the best interests of investors.  There are obvious benefits in spelling out these duties. 

There are also new restrictions on related party transactions.  These have been a minefield of conflicted interests in the past and proved especially troublesome for investors in finance companies through the GFC.

Managers must opt into the new regime between 1 December 2014 and 1 December 2016.  New managers setting up after December 2014 must start under the new rules (so you may see a flurry of new fund managers launch before December so they have 2 years to then transition to the new rules).

Final thoughts
Overall the regulatory change is good for investors and for confidence in local markets.  There will be significant new regulatory costs and time demands on fund managers which may or may not mean higher fees for investors (given competition in the market, we suspect managers won’t be able to pass these costs on).  While it will become harder for new fund managers to enter the market after December 2014, ultimately the new suite of regulatory changes are necessary and long overdue.

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.

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