Weekend Money: Beware the write-down

By Philip Macalister

Managed funds are a great way for investors to get access to professional investment skills and a broad range of assets, but they are not always foolproof. Three recent events in the managed funds industry show that in some circumstances things can go wrong and when that happens, people lose money.

In two cases managers inflated the unit prices of funds by adding in the value of tax credits from previous losses that subsequently became unrealisable. The end result was that up to 40 per cent of unitholders' value was wiped off with the stroke of a pen.

The third example is the ongoing struggle for survival of the $75 million New Zealand Rural Property Trust. This is the sad saga of a once-popular fund that has been hobbled by fundamental structural problems, and a weak rural sector.

Investors presently in the fund must decide whether it will eventually emerge from its long coma, or whether it is terminal and the plug should be pulled at a special meeting in Wellington on Wednesday.

The manager, Williams & Kettle-owned New Zealand Rural Property Trust Management, takes the former view and is proposing to close the trust and remove unitholders' redemption rights for five years. However, there is an "Action Group" of unitholders who strongly oppose the plan.

NZRPT's closure proposal is multi-faceted and includes many other issues such as management fees, governance and a capital repayment. Consultant PricewaterhouseCoopers describes it as "far-reaching" and says if approved, investors would be "giving up a significant right".

One thing all parties agree on is that the open-ended structure where the manager redeems units at net asset value on request is unsustainable because the fund's assets are large and illiquid.

In this case the fund has mirrored the primary sector and been doing poorly for many years. To redeem units the manager has had to sell farms in a depressed market.

The shortcomings of open-ended property funds were starkly exposed in Australia during the early 1990s. Then a rush of redemption requests nearly crippled the managed fund industry.

While all parties agree that the NZRPT should be closed and unitholders should redeem their investments in a market, there is bitter disagreement over how this should be done.

The manager insists unitholders wanting out use the secondary market run by Sharemart, however, recent trades there have been made at half the net asset value.

PricewaterhouseCoopers insists, in a trustee-commissioned independent report, that listing the trust on the New Zealand Stock Exchange would give investors improved marketability and therefore better value. This is a proposition that has been made in previous independent reports and by research house IPAC Securities.

Yet the manager argues against listing, citing the trust's small size, its lack of distribution history and the fact that the primary sector is out of favour with investors.

From the small investor's point of view this situation is exacerbated as control of the trust essentially sits with a group of unitholders that are either associated with, or supportive of, the manager. This group, which owns about 25 per cent of the units and includes Tainui-owned MDC Investments, has indicated to PricewaterhouseCoopers it does not support listing.

The other concern for unitholders is that unitholders are being given only one option to fix the trust when there are others which should be considered.

PricewaterhouseCoopers says an orderly wind-down of the trust is the base case scenario, against which any other strategy should be evaluated.

However, the major unitholders "do not favour a wind-down of the trust at the present time and that any resolution to this effect is almost certain to be defeated".

Unitholders could expect to receive between 92c and 99c a unit under a wind-up, PricewaterhouseCoopers says. This is about halfway between the net asset value of $1.25 (May 31) and the average secondary market price of 64 cents.

The New Zealand Rural Property Trust story is a case study of why open-ended funds that invest in property don't work. It's also an example of how unitholders have little influence over the manager. In this case many of the 4700 investors, research houses and independent consultants have been arguing the trust should be listed to give the unitholders a better market in which to trade their shares, yet the manager stubbornly refuses to do so.

Another managed fund issue the NZRPT closure proposal raises is the level of management fees. To sweeten the closure proposal, the manager is offering to reduce its fees and make them "performance-related" as well as make a 17 per cent capital repayment.

Instead of a 2 per cent annual cash fee, the manager is offering to split the payment into two components: cash and units issued at net asset value. However, the total fee is still based on the size of the fund.

PricewaterhouseCooper's analysis of the proposal and comparison with other property holding investment vehicles show that the fee is relatively high, even taking into account the relative size of the trust and the geographic spread of assets, and the changes make only small changes in the fee's monetary value.

PricewaterhouseCooper's other concern is that the "performance-related component" does not efficiently align the manager's incentives and rewards with the interests of unitholders.

The fee still remains closely tied to the fund's size, rather than to its performance. This is a real issue for unitholders considering the recent poor performance of the trust and its decline in value.

IPAC Securities general manager David van Schaardenburg says fees are a big issue for the industry as they reduce an investor's return. While there is talk of moving to performance-based fees, one must be careful of the details.

Perhaps the irony of the overall closure proposal is that PricewaterhouseCoopers labels it "fair and reasonable", not because it is flawless, but "primarily because the present redemption arrangements are proving unworkable, and likely to eventually be inequitable as between unitholders."

The other problem that has surfaced is the practice of managers rolling up the value of tax credits from previous losses in the unit price.

This has happened with two of the former Direct Funds Management (formerly Renouf Asset Management) equity funds, and three Prudential unit trusts that are now owned and managed by Colonial First State Investments.

In all these instances the funds had made significant losses in previous years when markets, and fund performances were poor. The losses made by the funds meant they then gained tax credits which could be used to offset future tax liabilities, as long as the fund kept a reasonably consistent unitholder base.

The Direct international fund had losses of 33.72 cents per unit, at March 31, and the New Zealand equity fund had losses of 20.65 cents a unit. The fund's accounting policies were subsequently changed so the tax losses would not be included in the unit price.

Under the change the international fund's price fell 41 per cent from 90 cents to 69c and the NZ equity fund price fell 23 per cent to 48.5c.

Direct was keen to keep the funds going by using a new manager so investors could enjoy the benefits of the credits when performance improved, however that has only happened with the international fund which is now managed by Australian-based Dresdner RCM Global Investors.

Direct has been forced to close the New Zealand fund because more than half the unitholders have exited it. Under tax rules the credits only stay with the fund if there is a set degree of unitholder continuity.

Because of the redemptions the fund has lost the credits and has become so small it is no longer viable, director Stephen Underwood says in a letter to unitholders.

Colonial First State Investments is in a similar situation with three of the ex-Prudential funds that have been included in its recent product rationalisation.

The New Zealand Equity Income, Japanese Opportunities and Asia Pacific Opportunities funds all have had their unit prices written down by up to 20 per cent because of a similar situation.

Details of the writedowns aren't clear, and Colonial First State Investments chief executive Bruce Abraham refuses to discuss the issue and explain the circumstances.

However, in a letter to advisers, Colonial says the prices it has struck for the funds are based on "the proceeds from realisation after taking into account the anticipated liabilities of the trusts."

• Philip Macalister is the editor of online money management magazine Good Returns (www.goodreturns.co.nz). Good Returns provides news on managed funds, mortgages and financial planning.