Brian Gaynor: Low rating for managed funds is no surprise

Morningstar's assessment of the New Zealand investment fund sector is spot on.

Its 118 page report, which is called Global Fund Investor Experience, gives us a D- and we are ranked last out of 16 countries.

Perhaps the only surprise is that we didn't get an F.

The mortgage fund debacle, brokers selling complex securitised funds to unsophisticated retail investors, fee-driven advice by unqualified financial planners, the small size of the domestic sharemarket and our strong bias for residential property clearly indicates that the domestic funds sector has serious problems.

KiwiSaver is a lifeline for the industry but based on past experience, and the woeful level of investor protection, there is the potential for problems in this area as well.

Morningstar divides its assessment into six main areas, the first of which is investor protection.

Canada ranks first in terms of protection while we are last (see table).

Canada has developed a substantial regulatory framework administered by the Canadian Securities Administrators (CSA).

The CSA, whose objective is to protect "investors from unfair, improper or fraudulent practices" has a comprehensive internet based database of all investment funds. In addition, the Investment Funds Institute of Canada (IFIC) provides guidelines on fund advertising and administration.

By contrast, Morningstar believes the "New Zealand Securities Commission is not sufficiently resourced and has not been effective in achieving industry consensus across a range of issues".

The National Government says that it will address our investor protection problem but the departure of Commerce Commission chair Paula Rebstock indicates that its words may not be matched by actions.

Rebstock was a formidable chair who performed her role with determination and vigour and doesn't appear to have attended many overseas conferences. By contrast Securities Commission chair Jane Diplock has made speeches in Brussels, Dubai, Milan, New York, Madrid, Manchester and Paris in the past twelve months and the Commission's travel expenditure has leapt from $140,000 to $564,000 per annum since she took up her position in September 2001.

Based on these observations the new Government seems to prefer regulators who adopt a light-handed approach, and travel extensively overseas, to those who take a strong stance on important issues.

Morningstar's second classification is transparency in prospectus and reports and we also finished last in this classification. The report is particularly critical of our investment statements, mainly because they do not contain enough meaningful information or the name of the fund manager. There is also no uniform information on fees or a history of expense ratios that allows investors to determine whether expenses have increased over the years.

New Zealand's best performance is in the area of transparency in sales and media, where we have been given a B and are in eighth position.

We receive a high mark in this area because direct brokerage arrangements, which is where fund managers direct portfolio transactions to particular brokerage firms in exchange for promoting their fund, is not practiced here.

In addition the media receives a positive tick because it "sometimes points out the merit of long-term investing and the negative impact of high fund costs". Fund costs are rarely mentioned by the media in most countries.

As far as fees and expenses are concerned we received a B- and are in ninth place. Our expense ratios are between 1.00 per cent and 1.49 per cent compared with 1.50 per cent to 1.99 per cent per annum throughout most of the world and between 2.00 per cent and 2.50 per cent in Canada and Japan.

According to Morningstar: "In New Zealand, costs are not an important consideration in investors' choice of funds."

Morningstar ranks us in last place in terms of taxation, which is clearly unjustified. This assessment seems to be based on the pre-portfolio investment entity (PIE) regime when unit trusts were subject to a full capital gains tax and additional high taxes on income.

However, since the PIE regime was introduced on October 1, 2007, all funds that are PIE compliant, and invest in New Zealand, are exempt from capital gains tax and have a maximum tax of 30 per cent on income.

If Morningstar had focused on PIE funds, which are now far more common than the old unit trusts, we would have received a higher taxation rating.

Finally in terms of distribution and choice, which covers minimum investment levels and the widespread availability of funds, we rank ninth.

In New Zealand only 10 per cent of funds have a minimum investment level of less than US$1,000 ($1,626). Morningstar considers this to be relatively investor unfriendly as five countries have minimum investment levels of less than US$250.

On a more positive note, investors in New Zealand have a full range of purchase outlets, including banks, insurance companies, sharebrokers, discount firms, financial planners and the internet. How did we get into the situation where Morningstar ranks us last of 16 countries and will the Government make any major improvements?

The battle over the protection of investors and wellbeing of our investment sector was won and lost after the October 1987 sharemarket crash.

There were a number of major reports on our securities industry, including the Russell and Roche inquiries, after the crash. They all concluded that there had been significant market failures and major changes needed to be made to our regulations and regulatory structure.

However the Business Roundtable and a number of powerful self-serving businessmen were at the height of their powers and successfully lobbied against any major changes. They received a sympathetic ear from important Government ministers, particularly Ruth Richardson and Bill Birch in the National Government in the early 1990s.

The main battle ground was the proposed takeovers code with the Business Roundtable on one side and the Securities Commission on the other.

The Commission, as is still the case, was not effective in gathering industry support.

The battle was conclusively lost at the Company Law Reform Summit, held on September 21, 1993, following a hard hitting speech by Alan Gibbs.

Gibbs told the influential audience that "those who are opposed to the code are greatly concerned about shareholder wealth" whereas those who supported the reforms were only interested in following overseas trends and "international conformity is not a welfare maximisation criterion".

This speech had a powerful influence on industry sentiment and in the mid and late 1990s a large section of the investment community, including the NZX, large law firms and major investment banks and institutions were vocal opponents of the code and most other securities industry reforms.

The Takeovers Code was finally introduced in July 2001. However, the battle over the code stifled any other major industry reforms and the 1990s was the lost decade as far as the sector was concerned.

The Securities Commission became increasingly irrelevant, the NZX lost its way, former Government owned companies were hopelessly managed by our high-powered businessmen and New Zealanders deserted financial markets for residential property.

The country's investment sector has never fully recovered from the lost decade.

The new Government, particularly Commerce and Justice Minister Simon Power, has promised reform but it is difficult to know where it should start.

The Morningstar report, and the recent collapse of the finance company sector, indicates that we need a comprehensive review and overhaul of the investment sector because investor confidence in the current regime is extremely low.

It would be unwise to wager that these reforms will be introduced because politicians have consistently failed to understand the importance of our savings and investment sector to the country's overall economic prosperity.

Disclosure of interest: Brian Gaynor is the portfolio manager of the Milford Aggressive and Milford KiwiSaver funds.