The danger of managed investment schemes

In a speech addressing the Agribusiness Association of Australia, David Bryant explains why tax-effective managed investment funds are fundamentally flawed and pose a significant risk to consumers.

The tax-effective managed investment industry has been a curious feature of Australia’s finance industry for at least three decades.

Probably due to our convict heritage and resulting egalitarian culture, our nation’s government has created two unique institutions: a public holiday for a horse race, and a system of tax avoidance, sanctioned by our tax collector.

In any country the horse race is considered with a sigh of delight, while our tax schemes would be called fraud.

Technically the unfortunate term ‘managed investment scheme’ refers to thousands of investment trusts involving property, shares and fixed interest that are administered by the Managed Investment Act.

However, the common use for the term managed investments scheme (or its acronym, MIS) is for the tax-effective schemes that involve mainly agriculture or forestry. The balance of this presentation will use the common meaning of MIS — that is, tax-effective schemes.

In many nations other than Australia, an ‘investment scheme’ is understood to be a secret or devious plan. And in those countries, the operator of such a scheme would be called a criminal.

But not in Australia.

In this country, a tax-effective managed investment scheme is a personal cash flow management tool recommended by our private taxation or investment adviser. The operator of the scheme is considered to be an integrated financial solutions provider.

This may seem like semantics, but at a time when international interest in our agricultural industry has never been greater, perhaps we should give some thought to how a foreign investor may view us.

You may ask, why bother with this when the responsible entities for more than half of the tax-effective MIS sector (measured by market share) have entered administration?

The reasons that we should bother are that the enabling legislation is still law, not all of the scheme promoters have gone broke, and Australian investors continue to invest in these schemes.

This tax minimisation industry has damaged its reputation more than once, but like mug punters on the first Tuesday of November, many poor souls in the future will discard the form guide and take a plunge on a well-turned-out proposition.

As a director of a fund management company that was owned by a tax-effective MIS company, I had the unusual opportunity to witness at close quarters the workings of this industry. What I have learnt is these tax-effective MIS products are just that: products.

And because they are products they cannot be investments.

You may think that I am now off on a tangent. But this is the distinction that I wish to draw.

Tax-effective MIS products are not investments because what they really are is a contractual arrangement between a taxpayer (generally an individual) and a promoter, whereby the promoter undertakes to carry out the operations of a business, so that the taxpayer can claim a deduction for the expenses of that business.

This taxpayer then is a businessperson, not an investor. And this businessperson has contracted the operations of their business to the scheme promoter.

Now here is the point of this distinction.

When a contractor (in this case the scheme promoter) receives a payment from a businessperson, they are not obliged to apply those monies directly towards the fulfilment of the contract. Instead, the money simply becomes the legal property of the contractor.

If that contractor subsequently goes broke before they have completed the contractual works, the businessperson has lost their money.

At present there are about 100,000 Australians who say they have lost their investment in their MIS scheme. But they didn’t.

What they lost was their business, which they founded by paying a contractor who has gone broke.

Unfortunately, just like individuals who have claimed in their tax return that they were carrying on a business, they were not afforded the protection that one hopes are the rights of an investor.

The issue here is a question of trust. The scheme promoter was not entrusted with an investment.

As a consequence they were not bound to set that money aside for the beneficiary of a trust. Instead the promoter received a contract payment, which left them completely free to use the money for whatever purpose they thought was appropriate on the day.

An interesting consequence of this distinction is that while the money is now all gone, there has been no breach of trust. Because there was no trust.

These reflections on the absence of trust serve to underscore the key point that I wish to make about the tax-effective MIS sector.

And that is this: a tax-effective MIS is a fundamentally flawed investment structure. In fact, it should not even be considered to be an investment.

The mistake that our legislators have made is that they have legitimised this industry through the Managed Investment Act and Australian Taxation Product rulings.

Having done this, the public was entitled to think that these things were investments. ‘Managed’ investments, in fact.

But due to the desire of managers to contrive new and ingenious structures to maximise deductions, bespoke and untested products keep developing like mutating viruses.

This viral spread of evolving structures meant that no regulator, much less an investor, could ever be sure that funds were protected. It is this relentless innovation of the ‘integrated financial solutions providers’, as they compete to maximise tax deductions, that undermined any safety that this industry may have once had.

And now, following the collapse of Great Southern and Timbercorp, the record suggests that this industry was never safe.

I now wish to turn to another aspect of the tax-effective MIS industry, which has been used by lobbyists and politicians to support its existence.

The sacred cow of the tax-effective MIS industry has been plantation forestry. And the temple that sustains this cow is Plantations for Australia: the 2020 Vision.

According to its website: “Plantations for Australia: The 2020 Vision is a long-term and living strategic partnership between the Australian Government, the State and Territory governments and the plantation timber growing and processing industries.”

The partners in this living strategic partnership are forestry related sections of the Federal and State Governments; Australian Forest Growers, an industry lobby group for mainly smaller scale farm forests; and A3P, the industry lobby group for large forestry and paper companies, including the tax-effective forestry companies.

The reason for this living strategic partnership is generally said to be the need for Australia to reduce its importation of wood and paper products. To achieve this, we were provided with the 2020 Vision that involved trebling the nation’s plantation estate from 1.1 million hectares in 1996 to 3 million by 2020.

This Vision must have seemed like a good idea to politicians at the time, but now, 14 years later, it is apparent that two problems have occurred.

Firstly, the Vision overlooked the opportunity cost of what else could be done with the land occupied by 2 million hectares of forest. Secondly it is now clear that the Vision spawned a very large industry that has destroyed billions of dollars of wealth for tens of thousands of Australians.

On the first point (that is, opportunity cost) the Vision in failing to consider the basic economic principle of comparative advantage. Ironically, comparative advantage was first observed during debates concerning the corn laws of England in 1815.

One little-understood fact relating to the corn laws is that they were actually about wheat. Corn at the time was the generic term for all grains, but primarily the main grain consumed in a region, and in England that was wheat.

Simplistically, comparative advantage in the context of Australia’s forestry industry can be considered in the following way.

While Australia has the resources to produce all of its own wheat and wood, it is possible that it may be to our advantage to produce our own wheat, and let someone else produce the wood.

There is a subtlety to comparative advantage that is worth understanding.

Even if Australia is the world’s cheapest producer of wood and wheat, it may still be to our advantage to import the wood. The reason for this is that if our comparative excellence is greatest in wheat production, then our resources will be best used growing wheat and then trading some of it for wood.

This aspect of comparative advantage is a beautiful thing and well worth understanding, if only for the fact that you can justify paying someone to mow your lawn.

Let me explain.

I am able to manage Rural Funds Management (RFM) and mow lawn more cheaply than anyone I know.

However my comparative advantage in managing RFM is greatest, and my time is finite.

For this reason, I can make more money paying someone to mow my lawn and then use that time to manage RFM. Wikipedia provides some excellent examples on comparative advantage that I recommend to those of you who wish to ponder this issue a bit more deeply.

Now back to the plantation forestry industry. The 2 million hectares that Vision 2020 is turning into forest must displace other land use activities.

Since it is unlikely that plantations will displace national parks, deserts or cities, all we are left with is the displacement of farmland.

Taking this simple point to its logical conclusion, Vision 2020 is in fact a partnership between industry and government designed to replace farmland with forestry. This is a logical, but astounding conclusion.

A review of literature published by Vision 2020 reveals a public relations machine geared to the production of rhetoric designed to reassure us all that the Vision is good.

Who could question the wisdom of displacing 2 million hectares of agricultural industry when you are told: “The 2020 Vision is one of our most important nation-building projects with significant implications for the national economy, for the environment and for sustainable regional development. ”

The Vision’s publications are exemplary in their supply of buzzwords designed to reassure. There are dot points about significant progress and key challenges, there are principles, outcomes, partners, and vision relationships.

Unsurprisingly there are also case studies, strategic elements, policy frameworks, and reassuringly there are even ongoing challenges and opportunities for the vision partners.

One thing that appears to be missing from the Vision’s publications is a proper explanation of the opportunity cost of this government sanctioned change in land use.

While there are case studies designed to demonstrate that there is no net loss of employment, there is no presentation of the comparative advantage that should be the real driver of the plantation industry.

In fact comparing the 19th century debates about the corn laws to the rhetoric of our 2020 Vision, one may conclude that our language and our analysis have declined.

There is a significant aspect to the Vision that leads one to question how this has ever been allowed to happen.

Since we were first given the Vision, the nation’s area under plantation has increased from 1.1 million hectares to 1.9 million.

Of this additional 800,000 hectares, around 87 per cent of it has come from tax-effective MIS investment.

Based on this statistic, one could be forgiven for thinking that the Vision is really just a government assisted lobby group for the plantation MIS industry.

This aspect of the Vision could be overlooked but for the fact that tax-effective MIS investment is generally a poor investment. In fact as the earlier discussion pointed out, tax-effective MIS is not an investment, it is an act of carrying on a business.

Therefore, if we look deeply into this issue, what we can see is that Vision 2020 is in fact a partnership between Government and the MIS industry designed to entice people into a business.

While this assertion may sound like a conspiracy theory, let me quote A3P, the lobby group that represents MIS, in their submission into an inquiry relating to the collapse of Great Southern and Timbercorp.

The plantation industry believes it can continue to work in a collaborative effort with Government, the regulators and the financial planning sector to continue to enhance the benefits of the industry, and the protection of retail investors, where necessary.

At this point, it is probably worth highlighting the big difference between making an investment and going into a business.

Going into a business is much more risky than most investments. Single businesses are poorly diversified, subject to many more risks, typically contain operational leverage and are highly illiquid.

The business of plantation forestry has no diversification, is subject to significant risks, experiences large variations in commodity yield and price, and is highly illiquid.

As such, plantation forestry is much more risky that most investments.

In the past three decades the MIS sector has been the subject of enormous government intervention, way beyond that justified by its scale. Since 1998 we have seen:

• around 700 Australian Taxation Office (ATO) product rulings from 1998 to 2010;
• the Managed Investments Act 1998;
• Tax Ruling 2000-8 Income Tax: investment schemes;
• a Commonwealth Senate Economic References Committee on Mass Marketed Tax-Effective Schemes and Investor Protection in 2001;
• a 2003 report from ASIC on mass-market tax-effective schemes;
• a High Court test case relating to non-forestry MIS schemes;
• the introduction of a 70 per cent test for forestry MIS schemes in 2007;
• the Parliamentary Joint Committee on Corporations and Financial Services inquiry into aspects of agribusiness managed investment schemes; and
• the Senate Select Committee on Agricultural and Related Industries, inquiry into Food Production in Australia — Impact of Managed Investment Schemes.

With the exception of superannuation, there is no other area of the financial services sector that has been subject to so much government inquiry and intervention.

Yes there is absolutely no other area of the financial services sector that has failed so appallingly. In the past year, probably half of the industry’s responsible entities, measured by market share, have entered administration.

How is that we have had so much government intervention and yet so much failure? The reason is probably because we have had so much government intervention.

The MIS industry is characterised by either novel industries that lack a track record of production or businesses where the rates of returns are too low to attract professional investment.

To overcome the lack of track record or the lack of return, promoters simply throw in a tax deduction, which they get approved by way of a product ruling from the ATO.

The introduction of the product ruling system in 1998 did more than anything to catalyse the growth of the MIS industry. In fact early prospectuses for these products commonly carried an ATO tick of approval on their cover, which made them look positively good for you.

Government assurance of tax deductions was the spark that lit the fire of a booming industry, with MIS sales reaching $1 billion per annum at their peak.

However, as the fire raged, concerns about the loss of tax revenue, their impact on rural communities, product failures and aggressive sales tactics meant that the Government had to step in and put out spot fires.

How then does government extract itself from its continuing involvement in this sector?

Given that it was the introduction of product rulings that allowed the industry to grow, the abandonment of this practice would be the best place to start.

In the absence of tax rulings, promoters would be left dependent on legal opinions to reassure prospective members that their scheme is tax deductible. Where the ATO disagrees with the legal opinion it could decline the deductions and allow the matter to be contested in the courts.

This may seem to be a very harsh treatment of the MIS sector, but surely it is now time to ask whether the general public would be richer as a consequence.

At its heart, the tax-effective MIS industry is a consequence of accommodating tax policy. Given the extraordinary failure of this industry, surely it is time for tax policy to be less accommodating.

I am not opposed to the plantation forestry industry. Nor am I opposed to forestry companies, foresters, or anyone else seeking to earn their living in that sector.

I also support the expansion of our plantation estate, providing it is based on sound market principles unassisted by trade distorting government incentives.

I do however think that we need to see Vision 2020 for what it really is.

It is a government-funded tool that promotes two things: a policy objective without proper economic justification; and the expansion of the MIS industry that has to date been a weapon of wealth destruction.

For this reason, I think that the Government needs to terminate its living partnership with industry and leave the forestry and paper industries to expand based on the merits of pure investment returns.

If they can’t, then let’s grow some wheat and swap it for some wood.

It is now appropriate to consider the funds management industry, since it was not just the tax-effective MIS sector that collapsed as a consequence of the GFC. Westpoint, Centro, MFS, Babcock and Brown, and Allco are examples of major fund managers that have destroyed the wealth of their investors in recent years.

An interesting characteristic of these managers is that they were either operating alternative funds or unlisted property funds. Both of these attributes are features of RFM managed funds, which means that there are lessons to be learnt from these failures.

Earlier in my presentation I drew the distinction between carrying on a business and investing in a trust. Let us now focus on this issue of trust.

When an investor places their money into an investment trust, it is an act of trust. In so doing, they surrender the control of their money, but become a beneficiary of trust.

The advantage of this arrangement is that an investor’s money cannot be legally swept out of an account and applied to other purposes.

In fact the money must be invested in accordance with the stated investment parameters set out in the trust’s constitution — which is in fact the deed of trust. This is the advantage the participants in tax-effective schemes did not receive.

One wonders during the dying days of the Great Liquidity Bubble, how many managers of highly leveraged investment funds stopped to consider the trust that beneficiaries had placed in them?

While no doubt the investments of these funds complied with their constitutions, is it possible that some managers may have lost sight of the fiduciary responsibilities that they owed the beneficiaries of their trusts?

Funds management businesses are classic money skimming operations. The manager does not expose their capital to the same risks as the investment fund, but extracts a relatively small proportion of the capital, each year in return for their management expertise.

However because the fee is relatively small, the manager needs to grow the amount of funds under management to ensure they cover their costs and make a profit.

It is this need to grow that is the greatest and most common conflict between a fund manager and their fund members.

Growing funds under management can be achieved in three ways: obtaining new equity flows, retaining profits, or increasing debt.

The third method, that is, increased debt, was the undoing of many funds and fund managers when the Great Liquidity Boom finally ended.

While the desire to grow a funds management company is generally viewed as rational behaviour, there is no doubt that the pursuit of growth can become irrational as the desire to grow becomes overtaken by greed.

Once greed sets in, it creeps through an organisation’s culture. It encourages greater risk taking, and even the taking of shortcuts. The cumulative effect of greed is that a fund manager pays too much for assets and has too many assets to manage.

Greed is often identified as an undesirable emotion for rational investors. There is, however, one thing worse than greedy investors: greedy fund managers. They are not only guilty of greed. They are guilty of a betraying the trust of their investors.

In my time as a fund manager I do not think we have been guilty of greed. Perhaps our sector has never been sufficiently fashionable for us to be tested or challenged by greed. In that time however, I am confident we have been guilty of stupidity.

Given that we attract fees from beneficiaries on the basis of our skills and reputed intelligence, then stupidity is just as equally a betrayal of trust.

Herein lays the challenge for my company, RFM, and any other agricultural fund manager at a time when our industry is blossoming.

How do we ensure that we never betray our clients’ trust?

David Bryant is the managing director of Rural Funds Management.