The great New Zealand savings rort

By GARETH MORGAN - Part 1

A common complaint from consumers about investing hard-won savings in the products of the investment industry is that the returns they get seem low.

Even during buoyant periods, retail investors find their portfolios do not reflect the performance of market indexes or the funds they are in.

A number of analyses here and overseas support anecdotal evidence that retail portfolios systematically under-perform the markets in which they are invested.

The Consumers' Institute recently published a study of fund performances over the 10 years to February 2003. It showed that investors in well-known funds run by establishment names such as Tower, BNZ, ING and BT averaged real returns that were only 30 per cent of the real returns the funds actually earned.

Nor was there any evidence of these professional investors outperforming market averages.

A study done for these articles aimed to find out why New Zealanders experience systematic under-performance of market returns.

A third of household wealth is tied up in financial instruments. Eradicating the systematic poor performance of the investment portion of those holdings is a prerequisite to better returns and hence higher savings and household investments.

This - rather than demanding that households invest even more in wasteful avenues, as the Government is doing through mandatory employer-provided superannuation - is the key to reducing dependence on state subsidies such as NZ Superannuation for retirement income.

Through a survey of the fees and taxes of typical investment products, we are able to explain how investors reap a mere 35 per cent of the real returns the market offers.

We conclude there is significant market failure in the financial services sector, suppliers reap an unfair advantage from unequal information, and that for the market to function competitively, regulatory reform is required.

Our method was simple. First we researched the various products and investment providers in the market, reviewing the fund fact sheets, investment statements and prospectuses.

We then employed investors to visit investment houses and ask questions on portfolio structure, fees and tax efficiency. They extracted information on fee and tax incidence to identify the differences between returns earned and those the investor receives.

The types of investment methods surveyed were:

1. Direct investment in traditional unit trusts. Products available from institutions included those of Tower, AMP and ING.

2. Portfolio investment in traditional unit trusts via a financial planner.

3. Personal superannuation schemes. These schemes are portable between workplaces but are locked up until retirement. Tower and AMP's products were considered.

4. Personal superannuation via employer-sponsored master trusts.

5. Individually managed portfolios. These offer two broad types of service. One is a master trust of unit trust offerings bundled into pre-determined portfolios, and the other a wrap service offering a blend of unit trusts, cash and direct holdings.

Those interviewed included New Zealand Financial Planning, Broadbase, Spicers and Grosvenor (through their financial planning subsidiary, Prospero).

The first table illustrates the proportion of the real (after-inflation) returns earned that actually end up in investors' hands compared with the ideal situation of no fees, no tax on capital gains.

It is based on a gross (pre-tax, inflation and fee) earned by the fund/portfolio of 10 per cent and an investment of $100,000.

It shows the fees from a financial planning firm offering an individually managed $100,000 portfolio in a master trust structure are likely to reduce the 10 per cent return to 6.46 per cent before tax.

Tax removes a further 2.31 per cent and inflation 2 per cent, leaving the investor with 2.15 per cent real, or just 31 per cent of the return that a tax-efficient, fee-less investment would provide.

The survey results for these investment offerings are summarised in Table 2. The portfolio sizes considered are of $100,000, $500,000 and $1 million respectively. The portfolio type is high-growth funds. We repeated the exercise for balanced funds and found no material difference.

The result is that investors receive just 30 to 50 per cent of what they would ideally. They forgo 50 to 70 per cent of the return possible by using the financial services industry. That is not a small margin to surrender.

The key contributors to the loss from using intermediaries are fees and tax inefficiency. How much each bleeds depends on the investment option. As a generalisation, 70 per cent of the reduction in return comes from fees and 30 per cent from the tax inefficiency of the products.

As the table illustrates, there is some relief from the gouging if more is invested, particularly if individually managed portfolio services are used.

Alternatives offer nothing to the investor in terms of economies of scale. But individually managed portfolio services can offer investors 10 per cent more of their return if they invest $1 million rather than $100,000.

For smaller investors the worst of the options considered is the individually managed portfolio that uses the master trust method.

Spicers' Mandate Portfolio service and NZ Financial Planning's Master Trust services are the weakest offerings we found, because of tax inefficiency.

Among investments of $500,000 and $1 million, the wooden spoon is shared between individually managed portfolios using master trusts and unit trust products generally.

Both have been designed for management efficiency without concern for tax consequences.

Notwithstanding the differences between savagely diminished (70 per cent reduced), and merely heavily diminished (50 per cent reduced) returns, investors need to be aware they cannot expect to make anything like market returns from these products unless their portfolio manager can consistently and substantially out-perform market-average returns.

None of the providers interviewed were able to demonstrate that. Several, in fact, seemed unable to provide any historical return information.

A number of consequences flow from the impact of fees' tax inefficiency. Here we consider one: how much one of these products has to earn just to meet the return the investor could get from the bank.

Bank deposit rates are now about 5.6 per cent, or 1.75 per cent after tax (1.65 per cent) and inflation (2 per cent). How much the respective products/services have to earn before their investor can gain this return is illustrated in Table 3.

If the investor pays no fees or tax on capital gains then the portfolio has to gross just over 4 per cent to match the bank deposit grossing 5.6 per cent.

The lower tax incidence of shares provides that advantage. But as soon as the investor has intermediaries involved, things turn to custard. On average a gross 8.5 per cent return must be earned just to provide the return of a bank deposit.

Worst in this regard is again the individually managed portfolio services using master trusts. Least-damaging are the illiquid super schemes using these trusts.

The extent of the damage inflicted over the ideal is alarming. So much is being gouged that the products/providers have to earn virtually twice the amount of the bank to deliver the same end result.

How often do retail funds earn twice as much as the bank? Based on 75 years of historical US data, we can expect the market to beat the bank about 56 per cent of the time.

But the chance of a fund beating the market in any one year is only 30 per cent (again based on US data, since the NZ funds management industry began with financial deregulation in 1984 and no long-term, market-based data exists).

So the average fund has a 16 per cent chance of beating the return from a bank deposit.

In the words of Clint Eastwood's Dirty Harry, are you feeling lucky?

This survey has sought to illuminate what lies behind the Consumers' Institute findings that investors receive less than a third of the possible return if they invest through the New Zealand financial services industry. Fees and tax-inefficient products are the culprits.

Our conclusion is that there is significant market failure in the financial services sector, suppliers reap an unfair advantage from an imbalance of information, and consumers are largely unaware of how much their returns are being nicked.

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