More standardisation needed across investment regulation to ease investors’ fears

Can a fund manager lose a large amount of your money by making bad investments?

Could their business go bankrupt and take all your investments with it?

What happens if they’re a crook and embezzle your money – will it end up buried in Barbados, never to be seen again?

For anyone who invests in KiwiSaver or any other managed fund, these are questions we want to know the answer to. It’s well publicised that the government doesn’t stand behind any investment scheme in New Zealand (not even KiwiSaver). We can only rely on the rules enforced by the Financial Markets Authority to protect us.

Does the regulator put enough laws in place to ensure we are informed about risk in a plain-English, plain-numbers way? Personally I don’t believe so, and we need to continually improve. Loss, bankruptcy and embezzlement are investors’ greatest fears.

It’s hard to stare down the barrel of language this tough and confronting, but in fund manager speak, investors are only asking about volatility, ring-fencing and retail protection. That makes it a bit more palatable.

1. Losing your money

When we ask, “how much money could I lose?” we want to get a grip on the numbers and test our emotional reaction to the answer.

Investors are human and full of contradiction. We don’t lose sleep and sell when a fund rockets up, but if we’re not prepared for the size or regularity of downturns, we panic and exit. Trading losses are exaggerated in funds with limited diversification (less shares) and with mandates to borrow money (buying more shares with borrowed cash magnifies losses). Yet most investors have no idea if leverage is normal (it isn’t) or if their fund is highly concentrated.

It’s time for the regulator to consider developing a more standardised way of communicating how funds really behave in a downturn. Education makes us more rational.

Falling values: If each manager reported their largest 1, 3, 6 and 12 month percentage losses in the last 10 years, investors would have a numerical idea of past downturns. It’s by no means perfect, nor does it predict the future, but it does deliver a snapshot. Managers could add the recovery time from each of these hits and a commentary about the event that caused it. Like a meteorologist taking a backdated look at large weather events and how long they lasted, we can prepare ourselves for local conditions.

Diversification: We need perspective on the number of companies our fund invests in compared to the market average. If the average across active funds is 100 holdings and you’re about to buy one with 20, there’s a clear indicator to expect greater price volatility and risk.

Fund borrows money: This magnifies investors’ gains and losses. Regulators should be prepared to create an ultra high-risk warning label to stop us thinking it’s normal practice. Think of cycling. Hills are categorised 1-4 in gradient. Beyond this it’s HC (Hors Categorie) or ‘beyond categorisation’. This is more honest than making a risk appear one-notch higher on a numbering system. Some funds could be excluded like those investing in property with a low borrowing cap.

2. Bankrupt fund managers

Is it possible for a fund manager to go bankrupt? Indeed it is. KiwiSaver and managed funds are run by big banks, insurers, and unlisted businesses with a handful of shareholders. Any could fail, but money in a fund won’t go with them.

We need simple standardised explanations to reassure investors their money never mingles with that of a fund manager. Investments are legally ring-fenced away from the managers business in a trust with a custodian and supervisor. The manager has to wait to receive fees from the trust to run their business and pay staff. If their business dissolves it would be highly likely another fund manager would step in and buy the right to run the fund.

That explanation needs polishing, but in essence it’s as simple as no mingling and ring-fenced funds.

3. Embezzlers

For all the regulation out there, it would bring tears to the eyes of the Financial Markets Authority to know how worried people are about losing large lump sums to investment scams, ponzi schemes or embezzlers who fake their returns and audits. We can’t blame them when they read about hundreds of millions lost with the likes of Ross Asset Management (David Ross) or Penrich (Kelly Tonkin).

Yet in reality, I scratch my head over how to embezzle a regulated retail fund. Having run them myself we huffed and puffed over legal sign-offs, companies office registration, producing fund accounts, audits and providing quarterly legal sign-offs to the supervisor that fund assets held by an independent custodian exactly matched unit numbers. How on earth someone squirrels out a sneaky 10 cents is beyond me.

Yet there are still two avenues of embezzlement risk left in our system.

The first is that of custody (the place where shares are held to stop them being lost or stolen). We don’t license or supervise custodians. We also don’t force them to be fully independent. They can be a nominee company with close links to the manager.

Second, are the rogue managers who get investors to agree they are “wholesale”, thus signing away their rights to retail regulatory checks and protection.

True wholesale investors have a treasury unit or in-house legal and risk managers, equipped to deal with limited disclosure. Unfortunately New Zealand law allows a small charity, a school board or someone with a villa in Herne Bay to declare they are rich enough and smart enough for the wholesale exemption. It also lets licensed financial advisers navigate them down this path, with no liability.

Luckily the Financial Markets Authority has clocked this and is due to tighten the law. The problem is it won’t be retrospective and thousands of people will be left in old wholesale arrangements like sitting ducks.

Janine Starks is the author of www.moneytips.nz and can be contacted at moneytips.nz@gmail.com. She is a financial commentator with expertise in banking, personal finance and funds management. Opinions are a personal view and general in nature. They are not a recommendation for any individual to buy or sell a financial product. Readers should always seek specific independent financial advice appropriate to their own circumstances.