Brent Sheather: 'Buyer beware' the lesson in times of crisis

The last two columns have looked at the precarious state of the world's financial markets and their propensity to lurch from one crisis to the next.

This is the last instalment of the series on that topic.

In the past 20 years, the typical response to financial crises has been for governments to bail out the major players by recapitalising companies, mainly banks, with taxpayer funds.

This strategy works in the short term but causes moral hazard - bankers think that if they take big risks there will be big bonuses but, if it turns out badly, they will get bailed out.

In a lecture to the London School of Economics, financier, IMF economist, fund manager and academic Paul Woolley suggested part of the blame for the dire state of the financial markets is the nature of the finance industry itself, particularly the investment (or fund) management industry.

He suggests a number of changes to the way major funds like our own NZ Super Fund employ fund managers, including:

Funds should adopt a long-term investment approach where they buy stocks on the basis of future dividend flows rather than price momentum.

Large investors - sovereign wealth funds, pension funds - should tell their fund managers that they may not turn over more than 30 per cent of the portfolio a year.

Investors need to understand most tools used to manage risk and return are based on the discredited theory of efficient markets.

Investors should adopt a stable benchmark for performance assessment such as the growth of GDP plus a risk premium.

Funds should not pay performance fees. Woolley argues that performance fees encourage short-termism and aggressive short-term trading behaviour, as well as costing a lot. Investors should not invest in alternative investments such as hedge funds, private equity and commodities.

I sent a copy of Woolley's "Resolving the dysfunctionality of finance" address to the Guardians of the Super Fund, David May (chairman), Gavin Walker, David Newman (deputy chairman), Mark Tume, John Evans, Catherine Savage and Stephen Moir. Their response is discussed below.

The NZ Super Fund has made quite a commitment to the alternative assets which Woolley says should be avoided.

As shareholders, the New Zealand Government and public need to know how much of our returns are being diverted to fund managers and others through performance fees, commission, management fees, investment banking costs.

The Guardians acknowledge the existence of principal/agents' problems in finance and that the investment management industry is, to a large extent, driven and greatly influenced by fund managers, stockbrokers and investment banks.

They also acknowledge that much of the pricing of investment services has been determined by managers and proposals to better align agents with principles are welcome.

The lesson for Mum and Dad here is caveat emptor - let the buyer beware. One way retail investors can try to get a better deal is to deal with independent advisers who don't take commission. Secondly, one should look at financial advisers' disclosure statements and note that the longer the disclosure statement the less attractive are likely to be the services.

Woolley says investors should direct their fund managers to buy assets based on cash-flow forecast rather than exploiting momentum trends. Momentum strategies buy what's going up and sell what's going down, causing investment bubbles.

The Guardians advise that only one of their fund managers uses a momentum strategy and this makes up just half a per cent of the fund's assets. So from our perspective, as the ultimate shareholders in the Super Fund, management get a tick for this.

For retail investors, the issue is to find out whether their fund manager uses momentum strategies or not.

Woolley argues that investors should not pay fund managers performance fees. The Guardians advise that about 30 per cent of the Super Fund's assets are subject to performance fees.

That doesn't sound encouraging when you consider 54 per cent of the Super Fund's assets are managed passively, where performance fees never apply, meaning that about 65 per cent of the actively managed assets are subject to performance fees.

This probably isn't surprising given the fact that a whopping 18 per cent of the portfolio as at June 30 was invested in alternative assets, excluding property.

Woolley is very much against alternative assets like hedge funds and commodities in that he doesn't buy the argument that the main attraction of these assets is that they provide the returns of shares with lower risk.

The Super Fund has made quite a big deal of its commitment to alternative assets.

Woolley reckons sovereign wealth funds such as the Super Fund should only invest in assets that are listed on the stock market. This is a reasonable rule for Mum and Dad to adopt as well because stock markets, with all their faults, tend to attract institutional investors who exercise a sort of policing role.

What's more, passively managed exchange-traded funds with ultra-low fees are becoming a more important part of world stock markets. The Guardians advise that 10 to 15 per cent of the Super Fund's gross assets are not listed on a stock exchange. Again this probably reflects the Super Fund's big commitment to alternative assets.

I asked the Guardians what fees the Super Fund actually pays to its alternative asset managers and, while they noted that specific fee arrangements for the funds are confidential, they said that, as an example, the typical fee paid to private equity funds was a base fee plus a performance fee.

The industry standard base fee is apparently 2 per cent a year plus 20 per cent of profits after the fund has returned 8 per cent. These fees are sky-high compared with those of exchange-traded equity funds of about 0.2 per cent a year.

Is it appropriate for a publicly owned fund like the Super Fund not to disclose the details of actual fee arrangements with fund managers? Why is this and who loses if this information is in the open?

The Guardians don't appear to understand or agree with Woolley's contention that the diversification benefits of alternative assets are illusory because they disappear when these strategies are widely adopted.

While the Guardians broadly agree with Woolley, they aren't convinced by his implicit suggestion that if all of the world's sovereign wealth funds followed his advice, this would affect the prices of the asset classes.

This is hard to reconcile with the fact that sovereign wealth funds and pension funds account for almost 40 per cent of funds invested in equity markets globally and, thus, must be hugely influential in the asset-pricing process.

In their reply, the Super Fund Guardians appear to reject Woolley's proposal by disputing the public-good benefits of his strategy. But this ignores the fact that there are substantial private benefits - that is, higher returns and much lower costs - for a fund adopting this policy.

Of course, even though we are shareholders in the Super Fund, this cost isn't quantified because the Guardians won't tell us the fees we are paying to the fund managers.

The bottom line for the public and the Government will be if the Super Fund can deliver competitive returns relative to a benchmark like the world stock market or, better still, a more stable and real long-term benchmark like the GDP growth plus an adjustment for risk, which Woolley suggests.

This column will be closely watching the Super Fund's performance in the future.

* Brent Sheather is an Auckland financial adviser and his adviser/disclosure statement is available on request and free of charge.