AMP + AXA = Bad for investors
December 2, 2009
PORTFOLIO POINT: The investment monster that would be created by merging AMP and AXA would mean bad news for investors.
It is shaping up as the financial services deal of the year: a combination of AMP and AXA would create a financial planning colossus with a 4000-strong army of product sellers. But the story that has yet to be rewritten is what this giant merger would mean for managed funds in Australia.
The proposal would spawn a monster force in managed funds - about 20% larger than its nearest rival - giving it unprecedented scale in a sector where excessive fees and underperformance are the norm.
Until now managed funds in Australia have been dominated by Colonial First State, owned by Commonwealth Bank, with $145 billion under management. But the melding of AMP and AXA Asia Pacific would see the second and fourth-largest players in the industry leapfrog to the top of a heap, with a combined heft of $175 billion under management.
Riddled with failings such as closet indexing, chronic underperformance and a cavalier approach to tax liabilities, the power in managed funds may be about to become even more concentrated.
Recent figures from ASIC put the size of the industry at $1.4 trillion. Compare this to the size of the Australian sharemarket, of just $1.32 trillion, according to the ASX. What we should be asking is does this $1.4 trillion sacred cow - which assuming a conservative average yearly management of fee of 1.2% generates $16.8 billion a year - really produce the kinds of returns that investors are seeking?
A recent Morgan Research study showed that more than 70% of financial planners' recommendations flow to the related fund managers, which should mean an impressive inflow into funds operated by AMP and AXA. However, the crucial question remains. Do managed funds work for investors?
Whenever this question is raised, the key objection is that we clearly observe some funds in the sample providing above-average returns. Surely these funds are managed by skilful managers and worth their 2% annual fees?
The most famous scientific study into this was one done by Mark Carhart, of the University of Southern California, who looked at the "persistence" of managed fund returns. He had a large sample of managed funds and sorted them into groups, from the best to worst performers over a one-year period.
He then looked at their performance in the next 12-month period, to see whether the best performers continued to do well, which would have suggested a skilful fund manager. He found little evidence of persistence, and the method he used (sorting performance from best to worse and seeing whether performance persists) has been used in future studies showing little evidence of "skill" in stockpicking.
Looking at the Australian superannuation industry - which is where a lot of money is invested in managed funds - Michael Drew and Jon Stanford of the University of Queensland published an article entitled Returns from Investing in Australian Equity Superannuation Funds, 1991 - 1999.
The authors found that, "As an industry, investment managers destroyed value for superannuation investors for the period 1991 through 1999, underperforming passive portfolio returns by 2.8-4% per annum on a risk-unadjusted basis". That is hardly a ringing endorsement of the industry, and managed funds. Of course, the headline performance figures for managed funds are before tax.
Slack on tax
Tax is another hurdle that the managed fund industry fails to clear on a consistent basis. The first problem is that they tend to pay a high level of distributions because of the sheer amount of trading that goes on in a fund. For example, when investors leave the fund, shares may be sold to pay their redemptions and any capital gains tax is distributed evenly to all investors.
With the exception of fully franked dividends for investors on a marginal tax rate lower than 31.5%, investors are best served by an investment return of untaxed, unrealised capital gains rather than large distributions.
An example of this in action is the AXA Australian equity growth fund. Its five-year return to the end of October has been 9.7% a year. This return has been made up of an average annual distribution of 15.3% and a capital loss of 5.1% a year.
The 15.3% distribution would have included some fully franked dividends, but given a market average income of 4-5% it would have been primarily taxable capital gains for investors.
Even the most admirable funds can be afflicted: Platinum International and the Hunter Hall Value Growth Trust have provided strong returns of 14-15% a year over the past 15 years, but these returns include a large proportion of taxable distributions.
Few active fund managers produce after-tax returns for unit holders. This is an appalling lack of information for investors; they pay good fees to these fund managers and deserve to have their after-tax returns explained to them in the same way as any investor in a low-cost index or industry super fund.
A key problem with managed funds is that many of them simply hold the same investments as the index, and in a similar proportion to the index, yet charge investors a fee of 2% for "active management". A 2007 study by Ross Miller of the State University of New York, entitled Measuring the True Cost of Active Management by Mutual (managed) Funds found that more than 90% of fund performance is simply related to the index (see Active funds' dark secret).
The biggest five stocks, in order of size, in the ASX 200 index at the end of October were BHP Billiton, Commonwealth Band, Westpac, NAB and ANZ. The biggest 5 holdings in the AXA Australian Equity Growth Fund (at the end of October) were BHP Billiton, Commonwealth Bank, Westpac, NAB and Woolworths.
The only difference between these AXA holdings and the index was Woolworths - which is the market's seventh-biggest company - hardly a brave and audacious stock selection. Note that more than 40% of the fund is made of the top five holdings.
For investors sick and tired of paying for this privilege there are many superior options, which are expanding all the time. These include selecting a well-diversified portfolio of direct securities, index funds and listed investment companies.
There is reasonable evidence that all of these options are often superior to managed funds. And yet $1.4 trillion invested either says that not only I am wrong, but far more importantly that the researchers and academics that have studied this topic for years are wrong as well. The only other conclusion that can reasonably be drawn is that Australian consumers have been let down by their financial service industry once more.
The most telling anecdote I can give is that of David Murray, the former chief executive of the Commonwealth Bank, who controls $65 billion as the guardian of the Future Fund. When Murray found that his reputation and the growing cost of public sector superannuation liabilities were on the line, he opted to use a core of index funds.
But then, as a former seller of managed funds when he ran Commonwealth Bank subsidiary Colonial First State, he knew the failings of these instruments better than most.