May 12, 2008

One of Australia's most successful superannuation funds has become the latest victim of the dramatic turnaround in stockmarket fortunes this year, and raised questions about the investment practices among top-rating local funds.

Following a large investment in the collapsed former investment bank MFS, the New South Wales Bookmakers Superannuation Fund is preparing to announce the first annual loss in its 30-year history.

In a bitter twist for investors in the fund, the loss will come after the fund recently opened its doors to the wider public with great success.

With a significant investment of more than 5% in the collapsed investment bank MFS (now rebranded as Octaviar) and related investment in the frozen MFS Premium Income Fund - along with other investments in the temporarily frozen City Pacific cash funds - NSW Bookmakers Super seems to have stepped on a string of "landmines" over the past year.

Peter Mueller, a director of Super Promoters, the fund's promoter, told Eureka Report: "There's still some time to go before June 30 but my instinct is that we are going to report a loss for the year. It will be in order of a few percent negative. It's been a very difficult year."

The news will surprise many in the industry who have watched NSW Bookmakers Super come to represent what looked like one of the unheralded gems of the superannuation sector. After turning into a 'public offer' fund in 2004, the fund has managed average annual returns of 12.7%. Until very recently it could boast of being a top five fund and of never having reported a loss in 33 years. (Its worst returns were 8% in 1997 and 2002.)

The fund's decision to go public had recently been yielding very strong results. The latest annual report, for 2006-07, showed membership and funds under management more than doubled that year, with 1073 new members joining the existing 918. The return for the year was 19%.

The fund's outstanding investment performance was not the only drawcard for new investors; it has an impressively low management fee, with an MER (management expense ratio) of about 1.1% "all-up''. The fund's low fee level has been one of its greatest achievements, director Peter Hayes William told Eureka Report in 2005.

The disappointing news will also highlight some of service levels at the fund, which is not "unitised", meaning it cannot show members how their investments are performing on an ongoing basis. Instead, members have to wait for formal reports; under the current non-unitised system, members of NSW Bookmakers Super might not officially hear the bad news until July this year.

In recent years there has been intense debate about the nature of investments being made by some of the best performing funds in Australia. In particular, there has been intense debate about the classification of private equity and even hedge fund investing in what were previously regarded as conservative "fixed interest" categories. (To read more about MFS Premium Income fund - one of the high-risk funds styled as a cash fund, which was used by NSW Bookmakers Super - see Scott Francis's comments, below).

"I'm afraid the MFS collapse really knocked us around," says Ian Buxton, a director of Super Promoters. "Although the amount of that investment had been reducing, it was a big exposure."


Scott Francis adds

The MFS Premium Income Fund was a key fund of the MFS group (since renamed Octaviar). The name implied it offered investors (including NSW Bookmakers Super) a strong income stream, presumably so that they could sleep comfortably at night. An investor update from November 2007 showed that the target rate of return was 9% a year for a 24-month investment. The fund was popular and had more than $770 million of unit-holder funds.

Lots of funds have reassuring names such as "cash plus" or "income" (even "premium income"), and the troubles the MFS Premium Income Fund got itself into is a reminder that investors should understand what is happening in every investment. Underlying the MFS fund was a small minority of cash and fixed interest investments; the majority assets were a series of property and "asset backed" loans.

The NSW Bookmakers Super Fund invested an estimated 8% of its members' money in MFS. The investment rating company Lonsec assessed the MFS Premium Income Fund as "investment grade"; in a fund review, although to be fair that was a review done about 18 months ago, in October 2006.

A key characteristic that investors should understand about the MFS Premium Income Fund is that it borrows to invest, something investors should treat with caution. As soon as a fund borrows to invest it increases its underlying risk. Borrowing to invest has been a considerable problem for the fund - earlier this year it defaulted on its loan, a $184 million facility that was payable to a third party bank.

The loan was repayable on demand as at December 31, 2007. This is where the fund started to struggle, and a series of letters to investors in the Premium Income Fund slowly highlighted the extent to which the fund was in difficulty.

A letter dated January 29, 2008, said that due to an "unprecedented" level of volatility in investment markets, no investors would be allowed to redeem their investment in the MFS Premium Income Fund for the next 180 days, adding that the fund "expects to continue paying distributions at the target rates".

This expectation about paying distributions seemed optimistic given that MFS Premium Income Fund managers should have known they were in default of the $184 million loan. It seems unlikely that any reasonable bank that was owed $184 million would say, ‘Sure, we are owed a bunch of money and you have defaulted on the terms of the loan, but we are happy for you to keep paying distributions to investors while we wait for our money'. Banks tend not to work that way.

And they didn't. In another letter to investors on March 19, the fund advised investors it was in default on a loan and that "under the terms of the standstill agreement with the bank" the MFS Premium Income Fund was not permitted to pay distributions to unit-holders without the approval of the bank.

And just when MFS Premium Income Fund investors felt it was safe to go back to their letterbox, a letter dated the April 14 announced that redemptions had now been deferred to 360 days "as stated in the Fund's constitution", and that ‘unit-holders will not receive interest payments during the period of the cessation, nor will any interest accrue".



So what is the cost to investors such as the NSW Bookmakers Super? As at February 29, an "investor update" listed the gross assets of the fund as $890.1 million, the loan of the fund at $184 million and the number of units on issue in the fund at 755.2 million. This gives a value per unit of 93¢, effectively a 7% loss on a $1 application price. Investors have now been without distributions for three months. Based on a 9% distribution, this is a "loss" of 2.25% (a quarter of 9%) - bringing the total "loss" to date to nearly 10%. Keep in mind that a good term deposit is currently yielding above 8%, so any money tied up in the MFS Premium Income Fund could be earning that in a low-risk term deposit with a bank.

A blatant example of a conflict of interest was the widely reported February drawdown on the unsecured $66 million loan facility made by the MFS Premium Income Fund to Living and Leisure Australia (a MFS/Octaviar subsidiary, whose primary activities are owning and operating ski fields, aquariums and property development).

The MFS Premium Income fund had already told investors that redemptions had been ceased; its managers should have known that the fund was in breach of the bank loan, and yet they (apparently) still thought the best way forward for investors in the MFS Premium Income Fund was to lend more money to Living and Leisure Australia, a company that had breached its own loan agreements in September 2007 (that is, Living and Leisure had already defaulted on the debt it owed).

The loans to Living and Leisure Australia are primarily in the form of unsecured loans, which means the investors in the MFS Premium Income Fund wait at the back of the queue behind all the secured creditors if Living and Leisure Australia collapses.

MFS/Octaviar Premium Income Fund investors - or anyone whose super fund was involved in this investment - should be furious about this misuse of the $66 million unsecured loan facility to prop up the Living and Leisure Australia trust.

The results suggest that the MFS Premium Income Fund was a risky fund. It borrowed money to invest. It invested in many related-party loans and tried to pay an ongoing income stream to investors while investing in assets that did not pay regular interest. All in all it stands as a good reminder that investors need to understand what is happening in their fund rather than assume that reassuring name like "premium income fund" provides any promise about risk and return.

Through all the "investor updates", investor letters, media articles and ASX announcements that I read, I could not find one that said that MFS/Octaviar had stopped taking fees from investors. Surely that is the ultimate insult: having to pay for that sort of "investment expertise" when you can't even get your money out of the fund!