The Great Savings Industry Wrought: How Investors get fleeced by New Zealand Investment Institutions
In the first of three articles on the results from a survey of New Zealand’s investment providers and products, economist and investment portfolio manager Dr Gareth Morgan considers why the Consumers’ Institute discovered that investors typically receive around a third of the returns their invested funds earn. In subsequent articles Dr Morgan investigates the reasons for the market failure that perpetuates these losses, what regulators are doing about it, and why it’s irrational for the New Zealand government to force even more of the public’s savings into the arms of this high-cost, poor-performing industry.
Summary of Findings
- Typically investors receive only 30-50% of the returns actually made on their money
- To make as much as what they could receive in the hand from a bank deposit, their fund manager has to make at least 8%. Historically sharemarkets have provided this order of return 5 years in 10, active fund managers just under 2 years in 10.
- To ensure the investor doesn’t actually lose wealth, the fund manager has to make a return of 6%. Sharemarkets provide this order of return 7 years in 10, active fund managers just over 2 years in 10.
- The long-term average real return from the US sharemarket over the last 75 years has been 9% pa real. Investors using products that currently proliferate in the New Zealand savings and investment industry, could have expected to average 3.5% pa real, from such a return, spending 3 years in 5 going backwards.
- 70% of the endemic underperformance comes from the level of fees (declared and undeclared), 30% from product design of poor quality such that tax liability is unnecessarily bloated.
- It is irrational for the government to pursue compulsory employer-provision of superannuation which force-feeds an industry with a track record of high costs and poor performance. To do so simply lines the pockets of providers, rather than meets the government’s objective of providing households with greater retirement security.
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An oft-heard complaint from consumers about their experience with investing hard-won savings in the products of the investment industry, is that the returns they get seem low. Even during periods of buoyant investment market conditions, the experience of retail investors is that their own portfolios do not reflect either the performance of market indexes or the published performance of funds they have been invested in.
A number of analyses of the performances of market indexes, unit trusts and the portfolios of retail investors both here and overseas, support anecdotal evidence that retail portfolios systematically under-perform the relevant markets in which they’re invested. Recently in New Zealand for example the Consumers’ Institute published a study of fund performances over the 10 years ended Feb 2003 showing that investors in well-known funds run by establishment names such as Tower, BNZ, ING and BT averaged real returns that were a mere 30% of the real returns that the funds actually earned. Nor was there any evidence of these professional investors out-performing market averages.
The study undertaken for these articles, aims 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 investment rates by households. This, rather than demanding that households invest even more in these wasteful avenues – as the government is doing, through mandating employer-provision of superannuation – is the key to reducing the dependence upon state subsidies, such as NZ Superannuation, for retirement income.
Through a survey of the layers of fees and taxes that retail investors in typical investment products pay, we are able to explain the empirical experience of investors reaping a mere 35% of the real returns the market offers. We conclude that there is significant market failure in the financial services sector, suppliers reap an unfair advantage from an asymmetry of information and that for the market to function competitively regulatory reform is required.
The Survey
Our objective is to reveal why retail investors are delivered returns that are a fraction of the ‘headline returns’ the underlying funds actually earn. We are not concerned in this paper with the other features of this sector,
- (a) that professional fund managers fail to add value – ie: to earn returns above the market average, and
- (b) that many fees end up as “backhanders” to financial planners who misrepresent themselves as the investor’s “adviser”.
These have been covered extensively elsewhere in the literature.
Our method is simple. First we undertook desk-based research on the various products and investment providers in the market, reviewing the relevant fund fact sheets, investment statements and prospecti. To verify the desk-based research we then employed ‘investors’ to visit a number of investment houses providing each investment vehicle type, and ask the pertinent questions on portfolio structure, fees and tax efficiency. They were able to extract the requisite information on fee and tax incidence in order 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. Typically these schemes are portable between workplaces but are locked up until retirement. Products considered included those provided by Tower and AMP.
- 4. Personal Superannuation via employer-sponsored Master Trusts.
- 5. Individually Managed Portfolios. A more recent innovation in the retail financial planning industry, these portfolio managers offer two broad types of service. One is a Master Trust of unit trust offerings bundled into pre-determined portfolios, and the other is a Wrap service that offers a blend of unit trusts, cash and direct holdings. The houses interviewed for their offerings in these areas 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 to 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% 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% return to 6.46% before tax. Tax removes a further 2.31% and inflation 2%, leaving the investor with 2.15% real or just 31% of the return that a tax-efficient, fee-less investment would provide.
The Survey results for these investment offerings are summarised in Table 2 below. The portfolio sizes considered are of $100,000, $500,000 and $1,000,000 respectively. The portfolio type is “High Growth Funds”. We repeated the exercise for “Balanced Funds” and found no material difference.
The typical result is that investors receive only 30-50% of what they would in the ideal situation. In short, investors typically forgo 50-70% of the return possible by using the financial services industry. That is not a small margin to surrender.
The key contributors to the loss of return from using intermediaries are fees and tax inefficiency. How much each bleeds returns is specific to each of the six intermediated investment options considered. As a generalisation 70% of the reduction in return comes from fees, 30% from the tax inefficiency of the products.
As the table illustrates there is some relief from this gouging if more is invested – this being particularly the case when individually-managed portfolios services are employed. Alternatives offer nothing to the investor in terms of economies of scale. But individually managed portfolio services can offer the investor 10% more of their return back, if they invest $1m as opposed to $100k.
For smaller investors, those with $100k invested, the worst of the investment options considered, is the individually managed portfolio option that uses the Master Trust method. Spicers’ Mandate Portfolio service and NZ Financial Planning’s Master Trust services are the weakest offerings we found in this space. It is the tax inefficiency of the investment products offered that is the downfall of this product type.
As funds invested lifts to the $500k and $1m levels the wooden spoon is shared between these individually managed portfolios using Master Trusts and Unit Trust products generally. Both share the awful aspect of being designed for management efficiency without caring about the tax consequences. This is their downfall.
Notwithstanding the differences between savagely-diminished (70%-reduced), and merely heavily-diminished (50% reduced) returns, investors need to be aware that 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 skill. In fact several seemed unable to provide any historical return information.
Beating The Bank
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: Not the highest benchmark we could set, but as we’ll see, still daunting!
Currently bank deposit rates are around 5.6%, or 1.75% after tax (1.65%) and inflation (2%). 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% to match the bank deposit grossing 5.6%. 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% return must be earned just to provide the return of a bank deposit.
Worst in this regard is again the Individually Managed Portfolio services utilising Master Trusts, while least damage is inflicted by the illiquid Super Schemes that use 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% of the time. But the chance of a fund beating the market in any one year, is only 30% , (again based on long-term US data, the NZ funds management industry being in its infancy since we’ve only had financial deregulation since 1984 and no long-term market-based data exists). So the average fund has a 16% 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 findings of the Consumers’ Institute earlier this year, that investors get 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 asymmetry of information and consumers are largely unaware of how much their returns are being nicked. We would suggest that with full knowledge of the discrepancies and the alternatives, they simply would not be as irrational to invest any funds to an industry that adds such measly value.
The apparent triumph of marketing over market information has implications for policy. For the market to function in a competitive fashion, regulatory reform is required to redress this asymmetry of knowledge in the market for retail investment products.
The next article will examine the causes of the market failure. There is condemning evidence that the industry misrepresents its services to investors.
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