This is the third in a series of blogs entitled “Trustee Investment Vulnerability”, based on an article written by Tony Molloy, QC, of Auckland.
I begrudgingly admit that I’m from America. I do so only to make this point of difference – in America, managed funds have a much better reputation than they do in New Zealand. And I think there are some good reasons for that:
- Until October 2007 managed funds in New Zealand were quite tax inefficient,
- Many managed funds here charge excessive fees plus performance fees (the Morningstar average is 1.33%, not including performance fees), and
- New Zealanders have admirable ‘Do It Yourself’ thinking that says, “Why should I pay someone else to hold investments I could just buy on my own”, and this is encouraged by the relatively small number of highly liquid New Zealand firms listed on the exchange.
These are legitimate points.
But if I could assemble a portfolio that addressed each of these concerns… If it was tax efficient, highly liquid, highly diversified and low cost, would the investors out there with a bias against managed funds consider changing their opinion?
Well, here’s a try.
Even Lawyers Have This Figured Out
Interestingly, the legal profession figured this out a long time ago. Below we quote from the article “Trustee Investment Vulnerability” where Tony Molloy, QC, cites an authority on the subject of picking shares or diversifying.
“Modern Portfolio Theory has taught us that the game of stock picking is costly and futile for most investors, especially small investors, while emphasising the large and essentially costless gains that are to be had from maximising diversification. These twin insights post the fiduciary investor—that is, the prudent investor– strongly toward the use of pooled investment vehicles that are large enough to achieve high levels of diversification at reasonable cost. The investment path of the future for trusts, especially smaller trusts is the mutual fund or the bank common trust fund.”[1]
Picking shares is “costly and futile for most investors”. These are sobering words for the money management industry. But this opinion is based on very broad and robust research.[2] However, the point here is that prudent investors are encouraged to use managed funds for two important reasons:
- Lower costs, and
- Superior diversification.
Taxes
Let’s discuss the taxes.
The introduction of PIE funds in October 2007 gave managed funds some significant advantages over direct investment. In summary, the law lowers fund investors’ tax rates by exempting realised gains from tax and excluding PIE income from personal income. Tax on income from a PIE is capped at a rate of 28%. This structure provides tax savings for investors on personal tax rates higher than 28% (i.e. 30% and 33%).
PIE income is also ‘excluded’ income. That is, individuals and trustees of family trusts do not need to include dividends from a PIE in their tax returns, although they can do so if they choose. Because of this, no further tax is payable on distributions from a PIE.[3]
In other words, taxes themselves are no longer the culprit they once were. In fact, some investors now have tax incentives to invest via managed funds. Still, old perceptions are hard to break.
Diversification
What is adequate diversification anyway? It’s hard to say really, but it involves more than owning a handful of Kiwi and Aussie shares and bonds. Bradley Nuttall includes approximately 8,000 underlying securities in our portfolios, from approximately 40 separate countries.
This variety of diversification just isn’t possible at “reasonable cost” if you buy shares and bonds direct. It’s for this reason that those who buy direct shares and bonds concentrate their portfolios.[4]
Lower costs
But broad diversification is available at “reasonable cost” using managed funds.
As professionals, we neither like nor dislike managed funds. We neither like nor dislike buying direct equities and debt. We are only paid by our clients and our only incentive is to do right by them. What we do like is offering our clients a highly diversified, low-cost solution that is appropriate to their specific circumstances.
The issue is simple – managed funds are able to purchase shares of companies like Fletcher Building for 1,000 investors at once, at a better price and at far lower transaction cost, than those 1,000 investors could purchase the shares themselves.
It’s not well understood, but a 2007 review of corporate bond transactions highlights the advantages large managed funds enjoy over small retail investors when purchasing assets. The study found that costs decrease significantly as trade sizes increase, with cited cost estimates ranging from 0.75% for small trades to just 0.04% for large trades.[5] These costs are often forgotten when purchasing shares and fixed interest directly, but when purchasing small lots (small trade sizes) the cost is real and it is expensive.
Tony Molloy’s article spoke about purchasing funds at “reasonable cost”, but clearly that needs a bit of definition. In our view, not all fund costs are reasonable. Bradley Nuttall believes “reasonable cost” to be quite low, less than one-third the average in New Zealand before even considering performance fees that, if considered, would push the average even higher.
If you buy and sell shares and fixed interest direct in New Zealand the lowest costs you’ll find are 0.35%, and most pay more. And you’ll pay that 0.35% every time you buy or sell, whether making contributions, taking withdrawals, rebalancing or investing cash dividends. To be sure, some managed funds charge to buy and sell as well, but typically at a lower cost. There is no direct charge to clients as the fund rebalances itself into new issues and to spread-out gains, to reduce concentration.
We use managed funds because it is prudent to do so. Not all managed funds are made equal. Some are quite expensive and not well diversified. But since we don’t have any in-house products and accept no commission, we only select funds that are very low cost and provide wide diversification.
Now that’s something you don’t need to be a lawyer to understand.
Find out more about Bradley Nuttall’s Investment Management and Wealth Management methods
[1] “Trustee Investment Vulnerability” NZLS Conference, Trusts June 2011, Tony Molloy, QC, of Auckland page 258. This is actually a quote from Justice Langbein in the “Uniform Prudent Investor Act and the Future of Investing,” 81 Iowa L Rev 641, 656-658 (1966).
[2] For a New Zealand based example see Rob Bauer, Roger Otten, Alireza Tourani Rad “New Zealand mutual funds: measuring performance and persistence in performance”, Accounting and Finance 46 (2006)
[3] http://www.craigsip.com/resources/pies.html
[4] This stance is often justified by saying that they only buy the “best” shares and the “best” bonds. Unfortunately this simple logic is deeply flawed. All they do is capture the same average returns, at greater risk.
[5] Edwards, Amy K., Lawrence E. Harris, and Michael S. Piwowar. 2007. “Corporate bond market transaction costs and transparency”. The Journal of Finance 62 (3):1422.
