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Are fund managers getting a free lunch?

05 October 2014  | 

LunchThe Age has covered a story that should be of great interest for all SMSF Trustees. Where does all that $20 billion in fees actually go? The Treasury estimates that it is about three times what it should be (it equates with about 1% of Australia's GDP). Someone is cleaning up.

Here is their graphic on it:





As The Age points out, there is no transparency on what fund managers are paid. It is a suspicious opaqueness:


"Fund managers are a key cog in the machine that disperses Australia's much-celebrated superannuation pile, which is headed towards $2 trillion. Fund management is not only about superannuation but retirement savings are easily the biggest part of the nation's total $2.3 trillion fund management industry. Based on current contribution rates and labour force trends, super's representation will swell to $3 trillion by 2020.

The super system is a chain of different organisations that encompasses insurers, asset consultants and fund managers.

When a super fund member makes a contribution to their retirement balance, part of it is deployed by the super fund into the hands of fund managers, who invest the money into shares, bonds or other kinds of securities. It is a good business to be in, with $20 billion of new money flowing in every year courtesy of compulsory superannuation."


The key problem is that these fund managers are largely guaranteed of a steady inflow of extra capital. Their only real competition is from Self Managed Super Funds (which is why they often refer to them with disdain). Plus they do not get any penalty when they get their investing wrong. It is pretty close to what economists said can't happen -- a free lunch:


"The true extent of the rewards on offer is unknown. But those in the know suggest it might include a cut of revenue allocated to a specific investment strategy, there could be performance bonuses and or perhaps equity in the firm or dividends earned on that equity.

And when things do not go to plan, there is no evidence of clawbacks in the event of client losses.

There is an irony, critics say, that as the annual general meeting season rolls around in coming weeks, the fiercest of the fund manager bunch will have already hosted chairmen in their offices grovelling for proxy votes. And one of the areas of greatest concern is the votes on remuneration.

As an aside, it is worth noting that there is encouraging evidence that this special breed of stockpickers are turning activist, wielding their influence to oust lazy management and bring attention to corporate ineptitude in the interest of better investor returns.

But on the accountability scales, fund managers themselves are under-represented."



The Age reports that Industry Super Australia, which represents the not-for-profit super funds such as AustralianSuper or UniSuper, has proposed a system-wide disclosure regime that would apply to fund managers. Unsurprisingly, the Financial Services Council, whose membership includes the big four banks which offer retail super funds and investment managers, does not agree. It is citing research that customers don't want it. Oh, and there is also the "competitive nature of the market".

The FSC correctly says what matters is net returns. But this picture does not look all that rosy. The average fee paid by a member is 1.1 per cent annually of their super balance. Over time, that will have a deep effect on net returns. There is little or no evidence that fund managers can beat the index over any reasonable time period, so 1.1 per cent is far from trivial. Especially when that figure should be going down as the industry achieves aconomies of scale.

There is nothing like a red herring to throw in:


"The FSC ... argues that a study of the Chilean retirement income system, which is comparable with the Australian model, shows that Australian members of super funds in MySuper-compliant products get value for money.

While investment fees were noticeably higher – almost twice that of MySuper's Chilean counterparts – that reflected the greater allocation to fixed income assets in the South American country.

(Equities are the dominant asset class in Australia, a reality that the system cannot find an easy workaround for.)

The administrative component of fund fees was similar in both countries."


Chile? There may be similarities between the two countries in some ways, but their capital market structures are profoundly different, as The Age points out. Australia has a deep stock market, Chile does not. That leaves fixed interest, which is not performing well.

The greatest challenge to these secretive fund managers, who cannot beat the index over time, is, logically, index funds. In the end, that will be a very difficult adversary:


"The rise of passive managers is providing some level of accountability.

These passive managers, such as index funds, offer exposure to the sharemarket at low cost. They simply structure their portfolio to mirror the composition of an index rather than trying to pick out the winners or losers.

These index managers are keeping active managers – the industry label for stockpickers – on their toes.

This is because a greater awareness is spreading of active managers who deliver passive performance, despite their claims of being able to pick winners, but charge as if they were delivering superior returns.

Passive performance would be a return comparable with the benchmark index. Active performance is, in effect, anything better than that.

The latest Mercer survey of Australia's long-only fund managers shows that the median share manager delivered a return over the 12 months to August of 15 per cent, beating the S&P/ASX 300 Index return of 14.1 per cent.

Over a quarter, the results are less flattering. The median Australian share manager produced a 3.4 per cent return, failing to beat the market's 3.6 per cent.

Looking at three- and five-year performance, stockpickers have it better: the median manager has outperformed the market by 1.4 per cent and 0.6 per cent respectively."



Index funds in Australia have their problems because of their heavy orientation towards banks and miners. The US index funds are more evenly distributed.

But the biggest problem will eventually be the fact that the amount of funds being wielded by super will be bigger than than the available local investment targets. At some point, the funds will have to be invested overseas.