Learning the hard lessons

By MARK FRYER

For a man who has spent much of the past few years wading through some dismal statistics, Don Phillips seems remarkably positive.

Phillips is managing director of Morningstar, the US-based company which monitors the performance of managed funds in many countries, including New Zealand, providing research to investors, advisers and the managers themselves.

As such he has paid more attention than most to the implosion of US sharemarkets, in which many investors have seen the value of their shares halved - or worse - over the past 2 1/2 years.

How bad do things look in the States?

"We've moved beyond the injury phase and we're into the insult phase," says Phillips. "It really is bad."

But in the midst of all that gloom, he says the managed funds business has provided some good news.

Good news item No 1: fund managers haven't been among the many US corporate heavyweights facing claims of fraudulent accounting.

They may have passed the effects of those scandals on to their investors, in the form of losses on their Enron, or WorldCom, or Tyco shares, but "there have been no direct cases where the managed fund industry in the States has been linked with any of the scandals, any of the accounting problems or any of the ethical issues that have faced corporate America."

Item No 2: all those scandals have proven the value of diversifying, which is one of the major benefits of investing through a fund, rather than doing it yourself.

"Even if you had the fund with the biggest percentage of their assets in those stocks [Enron or WorldCom], at most you probably had 5 per cent of your assets there and in most cases you'd have far less than that, so with a managed fund you live to fight another day," says Phillips.

"If you had a direct holding in one of those securities and say you own five to 10 securities total, then you would have had 10 to 20 per cent of your assets and then it would have been a much much bigger hit."

Item No 3: people are learning that investing isn't as simple as it looked - in the US anyway - in the late 1990s.

"People just thought that once-in-a-lifetime gains were commonplace."

The people who suffered most were those who started trading for themselves, "pooh-poohing all things that we learned over decades and decades, like the virtue of diversification, the importance of asset allocation, the notion that slow and steady wins the race - those things were all forgotten. And those people who forgot them the most got hurt the most."

He says US investors have learned that there are tradeoffs and that if you want a comfortable retirement you have to give up something in the short term.

"One of the illusions that people had in the 1990s was that the market would do all the heavy lifting for you; you just make the minimum contributions to your retirement plan, the market compounds at 20 or 30 per cent a year, and boom, you're set for life.

"People are realising that was an illusion, and that's a tough thing.

"The maths is not very attractive for many investors - they had their whole nest egg planned, based on assumptions that stocks would grow at unrealistic levels. Now a lot of them are saying, 'Maybe the retirement isn't going to be as comfortable, as I thought' or 'Maybe I'm going to have to work additional years' or 'Maybe I'm going to have to put an extra $100 a month into the retirement pool'."

All of which makes it easier for financial advisers to sell their services now than it was in the 1990s, when ideas like diversification seemed deeply old-fashioned.

Perversely, another piece of cheerful news - except, perhaps, for those concerned - is that some high-profile corporate misdeeds are now being punished.

"What's good now is you're starting to see some people go jail for this, and that's just very important ," says Phillips.

"Now you're starting to see a number of the Enron people - though it's taken 18 months or so - you're seeing them arraigned, you're seeing them face charges, you're seeing [former Tyco International chairman] Dennis Kozlowski being led out of his townhouse in handcuffs and that's very good for the system. People are realising that things may turn slower here because this is more complex, but the wheels of justice do turn."

However, he says fund managers could have been more active and stopped those abuses sooner.

Through all the downturns and scandals, he says private investors have defied many predictions by not panicking at the first signs of trouble.

"They didn't - it was professional investors who panicked and got out very quickly whereas fund investors have demonstrated more staying power than most people expected."

While there have been some withdrawals from managed funds, Phillips says they have been relatively limited.

Fund managers, whose fees are typically based on the value of the assets they manage, are suffering because those assets are now worth only a fraction of their previous value.

But Phillips says, "They're not hurting nearly as much as the brokerage houses - retail broking has just dried up completely."

Funds management firms are trimming back but they are not making heavy cuts, he says, and money management is "just one of the most profitable businesses imaginable".

He says one response to the market's plunge will be more fund managers offering performance-related fees.

In the recent past, rapidly-rising markets meant there was little demand for those fees, "so fund managers naturally didn't volunteer them. To me it just makes an awful lot of sense to align the management company's interest with investors and I think a performance-based fee is a great way to do that."

What about the eternal debate between "index" or "passive" managers, who slavishly follow a market index when buying or selling shares, and "active" managers, who try to pick and choose the best shares?

When markets were rising fast, and index funds were rising with them, many active managers forecast that the passive approach would come unstuck as soon as a bear market began.

Phillips says while it's true that recent years have seen more active managers beating the indexes, the bear market has not destroyed the appeal of the passive approach.

"Plus, there were a lot of [active] managers who had moved to a double weighting in technology ... who just did irreparable damage to their portfolios. So I don't think that active managers showed as well as they had promised they would show during this downturn."

While he's keen on the passive approach as a low-cost way of investing, he's less keen on managers who are supposedly active but still allow an index to rule their investment decisions.

"You had lots of people who sheepishly had to admit Enron was 2 per cent of the S&P [Standard & Poor's 500 index] so we put 2 per cent of our fund there even though we never did any research or due diligence on it."

He is also concerned about the movement of investors' money into fixed-interest funds, and whether investors understand that even those supposedly safe havens can lose money.

That is likely to happen when US interest rates eventually start rising.

"It's one thing to lose money on a stockmarket fund ... but to lose money that you think is stable - especially if you're used to bank products - that's where the fund management industry has got itself in trouble. Any sort of loss in something that the investor has pigeonholed as a safe investment is viewed as a violation of trust."

As for the future of the sharemarket, he says the consensus in the US is that investors should expect returns of about 7 or 8 per cent in future.

"But that's in a low-inflation context so it's not a terrible result. It's something where you can make progress towards your long-term goals. But it also means that if you've got absolute returns lower like that, you've got to pay more attention to the cost of accessing those securities."

* To contact Personal Finance Editor Mark Fryer write to: Weekend Herald, PO Box 32, Auckland. Email: mark_fryer@nzherald.co.nz. Ph: (09) 373-6400 ext 8833. Fax: (09) 373-6423.