Taking back control

Australian fund managers spend a lot of time and money wooing financial advisers with junkets, increasingly complex products and, of course, much-debated trail commissions. But there are now some advisers who are refusing to buy-in, and are opting for direct investing instead.

However, these financial planners are still in the minority, with recent estimates putting the sum of investors’ cash that advisers are allocating to managed funds at about $42 million, a figure that is growing monthly.

Wraps: an easy option for advisers?

Two years ago, the Australian Securities and Investments Commission (ASIC) warned that wraps and master trusts were being foisted on too many investors, regardless of the merits of such a move. RMIT University adjunct professor in financial planning Wes McMaster says advisers could be earning an income on as much as $142 billion in investors’ assets, but doing no work for it.

This estimate is based on a recent study McMaster conducted, which found 45 per cent of funds held by clients of 129 planning practices were not being actively reviewed. “One of the hallmarks of a true profession is that the professional is paid by the client, not a product provider. Imagine if doctors were paid by drug companies for the advice they give,” he says.

An in-depth study of seven practices showed 15 per cent of clients’ assets were not being reviewed, but still generating nearly $300,000 in revenue, based on assets of $658 million.

Lack of portfolio construction training

McMaster is equally concerned that, according to his research, 24 per cent of small financial planning practices exercise discretionary management over client investment portfolios, whether that is short-selling or picking direct stocks. “This is a funds management activity, and I have been concerned for some time that financial planners are not trained in funds management or advanced investment theory,” he says.

There are mixed feelings about this in the industry. Financial adviser John Hewison of Hewison & Associates in Northern Victoria is well-known in the planning industry for being a proponent of direct investing, but he stresses his advisers have no interest in shorting stocks.

“We don’t favour timing the market — we’ve tried it. If a stock is fairly priced using fundamental values and is a quality company with good management, we will buy it. We are not fund managers and don’t try to be.”

The primary focus of his business is to achieve reliable income, predictable and controllable taxation treatment, and risk management for his clients.

“Direct investment enables accurate planning and control of these issues where managed funds do not. Managed funds generally manage portfolios to a style or manager philosophy. We manage portfolios to meet the client’s specific needs,” he says.

The need for investment flexibility

Hewison argues that managed funds do not offer the flexibility needed to take advantage of market corrections, and cites 9/11 as an example where certain quality stocks and hybrids were marked down significantly. For those who were prepared to apply logic and take a medium-term view, he says, the event was “a licence to print money”.

In 1994 and 1995 the bond market saw managers continually get the market wrong, which prompted Hewison & Associates to survey rolling three-year debenture returns over 30 years, compared to managed bond market funds. The risk reward margin was 2 per cent before fees, so he looked at direct fixed interest investment as a much more productive alternative.

Clients of Hewison & Associates also weathered the 2000 to 2003 period without much stress. “This was because their portfolios were fairly steady and income was unaffected by market downturn. Many style managers were caught with their pants down, and Maple-Brown Abbott shone again as they always do when markets decline. Mixing style managers is a recipe for mediocrity in my view,” Hewison says.

The group does use some managed funds, however, including absolute return managers for the international component of clients’ portfolios, as well as listed investment companies whose track record has been “terrific for decades”.

Reducing client costs and fees

Griffin Financial Services proprietor Ray Griffin says, wherever possible, clients are invested directly into shares, and the main impetus for this is keeping costs down as much as possible. “When you take into account that master funds and wraps have their own management expense ratios [MERs], and the platforms have underlying MERs, the last one getting paid is the client,” he says.

Griffin says it is possible to have a concentrated portfolio and still do well for clients. His firm invests clients across around a dozen securities, as well as listed property trusts, hybrids and registered first mortgages, and the overall portfolio model is long-term and income-driven.

Clients’ only exposure to managed funds is for the international component of the portfolio, although wherever possible wholesale funds are used to keep costs to a minimum.

When it comes to picking stocks, the group uses an online broker and is underweight in some sectors according to the economic outlook.

“We are being very cautious at the moment — the easy money is gone, and planners have to be very particular about how they are getting a return for their clients. With a focus on income, at least we can sustain one component of clients’ returns,” Griffin says.

The benefits of portfolio administration

One of the great debates in financial planning has been whether managed funds are relevant to clients with low balances. The conventional wisdom has been that they aren’t, as the less you have to invest, and the less widely it is spread across different investments, the fewer benefits there are in having a portfolio administration service. Costs for smaller, less-complex portfolios are higher and automated reporting not important.

But determining the true cost of a wrap or master trust or comparing different services on the basis of cost is a difficult task. According to research by Tom Collins Consultancy, there are huge variations between wraps and master funds. Collins found with wraps that the annual platform costs could vary from 0.12 per cent to 1.75 per cent. On a $100,000 portfolio that’s an annual variation of $120 to $1,750. On master trusts the range is 0.75 per cent to 1.6 per cent.

Platform providers argue that investors are getting more benefits from master funds than if they were directly invested because of consolidated reporting at annual or quarterly statement time. An improvement has been the introduction of baby wraps, also know as ‘lite’ platforms or ‘mini master trusts’, with a smaller range of stocks to cater for clients with balances as low as $2,000.

The expense of going direct

Guest McLeod adviser Philip Guest has strong views on the use of managed funds and says the more money a client has, the more likely they are to “go direct on everything”.

“I never liked the idea of an index, but active management provides little long-term value unless the client has plenty to work with,” he says. “You need a fair amount to go direct, otherwise you are dependent on a couple of companies and subsectors — you’re not going to hold a $20,000 stock because it’s not worth doing all the admin,” he explains.

Guest McLeod’s clients are all in the high-net-worth category, but Guest says he would only create a wholly direct portfolio for those with balances over $3 million. The rest of his clients are invested in wholesale managed funds and low cost providers such as DFA and Vanguard.

When it comes to managing direct investments, Guest favours value over growth and always takes a long-term view. “We might buy a portfolio of direct shares, but we’re not looking to turn them over all the time; we just get rid of the dogs. There are some really good stock pickers out there, but they are rare, and it is hard to consistently add significant value.”

Improving managed fund products

Vanguard Investments Australia managing director Jeremy Duffield says fund managers need to offer better products and better fee structures to tempt advisers like Guest into using their products.

He says a particular issue in Australia is that younger investors are taking a more hands-on approach to investing. They are accustomed to doing their own research via the Internet, and in general are planning for the future more than their spendthrift parents. He says young investors prefer direct property and shares to managed funds.

“In the future, direct investing in shares and managed funds will be more popular as investors get more sophisticated over time,” he says.

In the US, mutual funds have become the preferred way of saving and investing, displacing ownership of direct shares.

“I think we have further to go in intermediating between consumers and securities markets,” Duffield says. “Direct property and share investing are clear competitors.”

Another major change awaiting the funds management industry is demographic pressure and a trend towards “dis-saving”, as the baby boomers move from an accumulation stage to distribution.

But despite the threat of these investors pulling out their hefty investment balances, which make up 78 per cent of funds under management, and spending the kids’ inheritance, Duffield says savvy fund managers can take advantage of the change.

“One of the areas of focus has to be on retirement products — dealing with the need for income and moving from the accumulation stage to distribution as the baby boomers look to spend down their assets.

“But I think we can make further strides against these competitors if we sharpen our offerings in the years ahead: more tailored services, lower costs, and further investor education.”

Access to fund research

Van Eyk Research portfolio manager Otto Reith agrees that the industry needs to change, and that includes improving the research available to advisers on investment returns. Van Eyk is currently looking at a way to categorise investment classes, including individually managed accounts (IMAs), index funds, and managed funds according to taxation, a project he says that will take many months.

Reith predicts index funds will come out well as they are actively managed, have lower fees, have a lower turnover, and therefore attract less capital gains tax. IMAs also fare well as the investor owns the tax and offsets it against their other investment income.

“It will be a hard job because there are no benchmarks for that kind of thing [calculating investment tax]. Some of the advisers I have spoken to are keen to find out the exact after-tax performance of products, rather than the usual ‘which manager was the last one to beat the benchmark?’ type stuff.”