Brian Gaynor: Taking ING's cash offer looks like no-brainer

Brian Gaynor

Investors in the controversial ING Diversified Yield Fund (DYF) and ING Regular Income Fund (RIF) have major decisions to make before July 13.

Their options are:

1) To keep their existing units in these funds.

2) Accept a cash payment of 60c per DYF unit and 62c for each RIF unit. The cash payments will be made by August 28.

3) Or accept the five-year option whereby the 60c per DYF unit and 62c per RIF unit will be transferred to an ANZ cash account where it will earn 8.3 per cent per annum for the next five years. Investors can access all or part of this money at any time over the five-year period.

What should investors do? Which option should they accept?

DYF and RIF, which are Australian unit trusts routed through the Cook Islands, have the following risk profiles and objectives;

* DYF, which has a moderate risk profile, was designed to outperform the 90-day bank bill rate over a rolling 12-month period by 2 per cent per annum, after management fees of 1.4 per cent per annum.

* RIF, which has a low to moderate risk profile, was designed to outperform the 90-day bank bill rate by 1 per cent per annum, also after management fees of 1.4 per cent per annum.

DYF peaked at approximately 587 million units in November 2006 and RIF at 258 million units in August 2007. As units were usually worth around $1 the combined annualised management fee for the two funds at their peak was nearly $12 million.

The accompanying table shows the structure of the two funds, which were heavily weighted towards collateralised debt obligations (CDOs). These CDOs represented 63 per cent of the DYF and 78 per cent of the RIF at the end of June 2007.

A CDO is a security backed by a pool of bonds, loans and other assets.

In simple terms a CDO comprises six different tranches as follows;

* Tranche A, which is about 75 per cent of structure, contains AAA credit rated securities.

* Tranche B, 5 per cent with AA rated holdings.

* Tranche C, 5 per cent with A ratings.

* Tranche D, 5 per cent with BBB ratings.

* Tranche E, 2 per cent with BB ratings.

* Equity, 8 per cent and the holdings are not rated.

DYF and RIF's investment statements disclosed that they would invest in "collateralised debt obligations (CDOs) with a targeted average credit rating of BBB".

In other worlds ING was targeting tranche D in a CDO structure and, as it was aiming for a BBB average, also purchased securities in tranche E and equity.

ING must be hugely embarrassed by this strategy because the names of the individual investments, and their credit and tranche ratings, have not been disclosed in the Dynamic Credit report that accompanies the current proposal. This high-risk approach is understandable when it is considered that the fund aimed to achieve a return of 2 per cent and 1 per cent above the bank bill rate, after fees. To achieve this level of return in the US and European credit markets the funds mainly invested in lower ranking tranches, which offered higher interest rates. What is not understandable is how RIF had a slightly higher risk portfolio than DYF even though it had a less demanding performance target and was promoted as a "low to moderate" risk investment.

The DYF and RIF debacle shows once again that our prospectus and investment statement regime is woefully inadequate as the documents did not fully explain the nature of the investments and the risks involved.

The investment statements contained photographs of individuals happily lying in a hammock or having a barbecue and drinks on the beach but contained almost no explanation or analysis of CDOs.

The investment statements' main message was: "trust us (ING); we know what we are doing". The section on "what are my risks?" concluded with the comment "by investing in the fund, you benefit from our (ING) professional skills in evaluating each CDO".

The tragedy is that ANZ Bank, which owns 49 per cent of ING, promoted these funds to elderly investors whose main object was to preserve capital while obtaining a reasonable income return.

The problem is that the default rate on the speculative tranches of CDOs, where ING has invested the funds' money, could be as high as 55 per cent over the next five years, according to Credit Suisse First Boston, compared with around 45 per cent in the 1930s depression. ING didn't seem to consider the prospects of a worldwide economic downturn when constructing these high-risk portfolios.

The CDO market below tranche A is now dysfunctional, liquidity is low and valuations are uncertain.

For example, there are also no cash-flow projections for 54 of the 138 CDO structures held by the funds with the independent adviser believing that 40 are largely worthless.

As the accompanying table shows Grant Samuel now values DYF at 22c per unit, compared with ING's cash offer of 60c, and RIF at 18c compared with the 62c offer.

Grant Samuel believes the offers are fair because they are substantially higher than the valuations in the previous paragraph and the bid and ask prices as at December 31 last, which values the funds at 24c per unit for DYF and 21c per unit for RIF.

There are a number of issues that concern ING investors including:

They have to accept in respect of all or none of their units.

Investors who accept the offer waive their right to pursue or benefit from legal rights or claims against, among others, ING NZ, advisers and the trustee.

The latter issue is important to many investors although the prospect of getting back more than 60c or 62c per unit after successful legal action is unlikely.

ING is proposing to pay out approximately $264 million more than the funds are currently worth, which is consistent with ANZ Bank's pre-tax write-off of $116 million for its effective 49 per cent share of the two funds in its results for the six months to March 31.

The only rational decision for investors is to accept ING's cash offer and then choose between option 2 and option 3, depending on individual circumstances.

Investors who keep their units face huge risks because ING says it will not liquidate the funds, they may be worth even less than 22c and 18c per unit in the future and the outcome of any legal action is uncertain.

But ING's cash offer doesn't solve the central problem, which is the woeful state of our prospectus and investment statement regime.

Investment statements, which are the predominant offer document, are little more than advertising brochures containing ridiculous statements and photographs of smiling individuals. For example the RIF offer document highlighted the following inane statement; "Imagine not having to dream about the things you want in life - imagine doing them."

Isn't it about time that Jane Diplock and the Securities Commission rose from their slumber and started insisting that offer documents contain a clear description of the securities on offer and an assessment of the risks involved? Until this issue is addressed we will continue to have investment products where investors lose their savings, mainly because the offer documents do not accurately reflect the true underlying nature of the proposed investment.

Disclosure of interest; Brian Gaynor is an executive director of Milford Asset Management.

bgaynor@milfordasset.com