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THE AUSTRALIAN, SATURDAY, OCTOBER 7, 2017 theaustralian.com.au/wealth THE WEEKEND AUSTRALIAN, OCTOBER 7-8, 2017 theaustralian.com.au/wealth
WEEKENDWEALTH Exchange traded funds have their problems JAMES KIRBY
Exchange traded funds are the hottest thing in Australian investments markets this year — they are selling like hot cakes. They are a very welcome addition to the menu for private investors but unfortunately they are not perfect. Crucially, ETFs — which are basically funds based on an index that are themselves listed on the stockmarket — have always offered the attractions of lowcost and simplified structures. Put simply, a private investor can buy an index such as the resources index. Or, better still, an investor can delve into previously arcane areas such as emerging markets or specialist fields such as US technology stocks through ETFs. But the change that put them front and centre of the market was the recent imposition of socalled FOFA regulation on Australian financial advisers, which meant commissions from fund management firms were no longer available. Suddenly the recommendation of ETFs from financial advisers became a ‘‘nobrainer’’ — importantly, no adviser could get into trouble for recommending an ETF, like the IT salesmen who never got into trouble recommending IBM. On a macro-basis there are some concerns with the success of the ETF market — in essence there is a fear that if a very large part of the market was no more than a mirror of the actual market (that is, ETFs were as widely held as shares themselves) we may face trouble. Certainly, if there is a sharemarket crash then the wider presence of ETFs will accelerate any drop, and vice versa it should accelerate any recovery. Either way these are realistic concerns. However, most investors are willing to explore the sector with that issue on the table. It is the less obvious operational failings of ETFs that do not get sufficient airplay. Here are a few things you may not know.
Exit strategy In common with managed funds, ETFs should not be a set and forget investment. As Kris Walmsley at ETF Securities suggests: “In common with any fund an ETF is not perpetual; there will be closures and that only makes sense at times.” Industry researcher Zenith has reported that 17 Australian ETFs actually closed up shop recently, leaving investors with their money returned and strategically at a loose end. In the managed funds arena this ongoing closure of weaker
products gave rise to what academics call ‘‘survivorship bias’’ — the stated success of any set of managed funds does not include the dud funds that closed down. In the ETF arena a similar pattern is forming. Already just 11 providers control more than half the market (see graph). This will become a bigger issue.
Riskier products
Holding out in the hot seat between business and best practice
In theory there is no other risk in an ETF than the risk presented by the index it follows — in other words, you will do no worse or better in a Nasdaq-based ETF than whatever might occur on the Nasdaq. But more recently ETF providers have begun to offer ETFs with a twist — some of these products are described as ‘‘smart beta’’ or ‘‘active’’. Basically, the providers are ‘‘enhancing’’ the formula. It may mean leaving things in or out of the index; it may mean adding some element of leverage (loans) to the product. In summary, it means the ETF is no longer a simple mirror of the underlying index and that means the introduction of risk and the subsequent introduction of variable returns from the index.
ANDREW HEAVEN
I’ve received advice to rebalance my portfolio of managed funds. I note I’m being charged fees by the fund managers for the transactions involved. These fees are referred to as a “buy/sell” cost. My financial adviser told me there would be no switching fees. These look like fees to me. Should I be concerned?
Indiscriminate investors The traditional ETF product that dominates our still early-stage market simply mirrors the index. It will buy stocks that are unworthy on every criterion other than market capitalisation. Worse still, it will buy stocks that fail ethical criteria such as pollution or gambling because it simply must reflect the wider index. There is some early movement among leaders such as Vanguard and SPDR to exert influence at AGMs, but there is a long way to go on this front, and more commonly an index-based ETF will, by definition, be indiscriminate in its underlying stock selection.
DAVID GERAGHTY
cap
Specific risks As the latest wave of ETF enthusiasm moves towards bond-based funds it’s worth pointing out some important differences. Basic diversification principles tell us we have bonds not just for income but to offset the specific volatility risk of shares. In ideal world an investor might have what they call a ‘‘ladder’’ of bonds with increasingly lengthy maturities, but in the real world most Australian investors don’t. At a glance the idea of a bond ETF solves the problem — an investor is promised immense diversification to many bonds at many maturities — but there is one glaring flaw here: it is a listed security on the ASX. It’s tradeable. It can be sold in a crisis. If the markets take a dive then in theory bond funds should be unaffected, but history tells us when the markets crash investors sell anything they can … don’t for moment think bond funds will be an exception.
THE COACH
RICHARD FERGUSON
Dean Paatsch is one Australia’s best known proxy advisers. As CEO of Ownership Matters he advises investors on how to vote on company resolutions. As a key intermediary in the market between business leaders and the investment community he has gathered both influence and criticism often in equal measure — but he has no plans to back down as a campaign forms to tighten rules in this area.
What does a proxy adviser actually do? We advise institutional shareholders their ownership rights. Specifically how they may use those rights at AGMs or extraordinary general meetings to enhance their value. That might involve voting against a renumeration report or a director’s election. About eighty per cent of AGMs take place in a six week period so there’s an extraordinary amount of work to do in a very short period of time. So you’re a kind of diplomatic link between institutional investors and companies? If we’re diplomats … we’re failing badly (laughs). Are you asking the questions institutional investors are too scared to ask of the companies they invest in? We do sometimes provide a bit of cover for institutions who want to retain good relationships with
company boards and management. We’re not constrained — we don’t work for companies, we work solely for investors — so we’re not shy about asking questions.
There have been calls to tighten regulation over proxy advisers. What’s your reaction to those who want reform? We’re already regulated like any researcher or investment bank is. We are rightly regulated and we comply 100 per cent with those rules. What the debate is really about is regulating things like having an opinion on a director’s election which don’t fall under the Parliament’s view of what is a regulated activity. It’s become a bit of a farce really. It is lamentable organisations like the AICD (Australian Institute of Company Directors) and the Australian Investor Relations Association — groups that usually advocate the removal of red tape — are seriously impinging on freedom of speech. Those groups seriously advocated that we should provide copies of our research for their approval and vetting before publication to our clients … It’s ridiculous. What do you think is behind this push to change the way you operate? Well, I just don’t think we have anything to fear from a free market sorting it out. People who are clients of proxy advisers are sophisticated, wholesale investors who
are capable of working out if the advice you’re giving him is rubbish. It’s the shareholders who vote, not the proxy advisers. It’s insecurity and unpredictably that’s driving the so-called push for regulation. But it’s also the lack of willingness to criticise shareholders who have followed poor recommendations quite frankly.
Ownership Matters has been in the news for its work with BHP shareholders. Why have you been so supportive of the Big Australian given its recent troubles? Once again, we don’t work for any listed company, we work for the investors. From an investor’s perspective, BHP’s performance has been terrible. I won’t deny we’ve been front and centre on calling for more board accountability after a period of disastrous capital allocation. Why did you advise against two resolutions up before the BHP AGM to open up shareholders’ rights to send up resolutions and to shift its funding from the Minerals Council? We’re supportive of a company having a well thought thoughtout policy on political funding but we didn’t think this particular solution from the Australasian Centre for Corporate Responsibility helped investors’ interests (The ACCR is a non-profit ethical investing lobbyist group). In the US, if a shareholder owning $2000 (US) worth of stock can put an advisory resolution, it
seems bizarre we’re still trying to use archaic means like constitutional reform to get there. The time’s coming when shareholders will be able to put these resolutions but it may take a few years.
Do you think companies should be campaigning on issues like same sex marriage? I don’t see that there’s an issue honestly. Political funding more generally is something that has received a lot of regulatory attention. But campaigning on social issues? As long as you’re open about it I think it’s uncontroversial. How did you get into the business of proxy advising? I began working in an industry association for the non-profit super funds and identified early that their ownership interest in Australian companies would rise rapidly but they didn’t seem to have a good handle on the potential governance risks that could result from absentee ownership. I guess I fell into proxy advising really. We’ve been operating in this guise for six years. For the previous ten years I’d been working with other companies. Proxy Australia was the first iteration; we were taken over by ISS, a multinational What are your own investments? I’ve been a lucky investor in the property market and in some managed funds. My focus is on minimising my risk.
When you invest or divest money in a managed fund, the fund manager may incur costs such as broking, stamp duty, taxes and other transaction costs to buy or sell the underlying assets in the portfolio. The fund levies these costs from the investor who is entering or exiting the fund. The cost of the transaction is referred to as a “buy/sell” cost — or spread — and is an estimate of the costs associated with the purchase or sale of units in the fund. Existing investors in the fund are not levied these costs as it would be unfair to penalise members of a fund who are not generating the transaction costs. In contrast, a management expense ratio (MER) or indirect cost ratio (ICR) is the ongoing management cost of the portfolio, expressed as a percentage of the funds under management, and is levied against the entire managed fund before a unit price is declared. A managed fund unit price is typically disclosed as an entry or exit price. The buy/sell spread is the difference between the two figures. The buy/sell spread may vary depending on the flow of money into or out of a fund on a given day. For instance, if a fund has a net inflow of funds, it may not have a sell spread as it is not having to sell the underlying assets in the portfolio. Details of the estimated buy/sell spread should be disclosed in the product disclosure statement (PDS) of the fund. Estimates of buy/sell spreads will vary depending on the type of assets being bought and sold and the complexity of the underlying portfolio. Buy/sell spreads will typically vary from between .05 per cent for assets such as fixed interest up to around 0.3 per cent for property. So if the average buy/sell spread of your portfolio is 0.18 per cent and you are switching $500,000 of investments, the cost will be $900. Some managed fund products may charge a unit switching fee, and these costs can be up to 1 per cent. Your adviser may be referring to this fee as not being applicable. As to whether you see a buy/sell spread as a switching fee is a matter for debate. Bottom line, there are costs to buying and selling the assets of a portfolio and someone must pay them, the logic being the fees should be incurred by those creating the cost. Your adviser may have good reasons why they wish you to rebalance your portfolio. They may wish you to do it to reduce risk or reorientate the portfolio to a risk profile aligned to your needs. They may feel there is a reason to remove a fund manager or replace a manager with one with better prospects. Your circumstances may also have changed and you may need to make changes as a consequence. Ask your planner why they are recommending the change and if you are unhappy with the reasoning, seek a second opinion.
Visit the Wealth section at www.theaustralian.com.au to send your questions to Andrew Heaven, an AMP financial planner at WealthPartners Financial Solutions.
Bubble trouble as online shopping giants inherit the questionable logic of logistics ROGER MONTGOMERY
It’s time to ask whether the tyranny of distance becomes the achilles heel of the giant online shopping networks … or to put it another way, are logistics companies part of the online boom or part of its problem? Last week Chinese online shopping behemoth Alibaba announced it would raise its stake in its logistics network affiliate Cainiao from 47 per cent to 51 per cent by shelling out $US807 million ($1bn). That’s an implied valuation of $US20bn for Cainiao. Cainiao is a logistics platform
set up in 2013 by Alibaba that allocates online orders to logistics companies. Unlike Amazon, the arrangement allows Alibaba to keep logistics at arm’s length, to control the logistics without having to do the heavy lifting in terms of labour or transport equipment. With 70 per cent of their volume coming from Alibaba and parcel deliveries expected to exceed 70 billion units in China by 2020, the value of Cainiao to the logistics companies is easy to understand. But if you are an online shopping platform, a viable logistics operation is equally essential. So essential is Cainiao to Alibaba and its ecosystem, for example, that Alibaba was willing to consolidate over $US300m of annual losses on to its balance sheet. So logistics companies need the online shopping platforms but the shopping platforms also need logistics. And while Amazon and
Alibaba are going about supporting their logistics operations with differentiated strategies, it appears ownership of logistics and its associated economics is not nearly as attractive as the businesses that make them viable. Take your mind back to 2015 when Japan Post purchased Toll Holdings for $6.5 billion — 49 per cent more than the previously traded price. It was an event that caused me some personal consternation, because although I didn’t think Toll was a high-quality business or worth anywhere near $6.5 billion, there was a problem: the Toll shares were in an index against which one of our funds is benchmarked. The steep rise in the share price pushed the index up and made it tougher for us to outperform. Japan Post had planned at the time to use Toll’s expertise in mergers and acquisitions to take a bite out of the growing volume of
online-generated parcel delivery in Asia, the US and Europe. Earlier this year, however, just two years after buying, the Japanese postal service took a $4.9 billion ‘‘big-bath’’ writedown on Toll, wiping out all the goodwill and taking a further $400m hit on the value of the trademark and fixed assets. Japan Post put the loses down to poor management and a weaker economy but in reality the losses came down to paying too much and the poor economics of logistics. More worrying for the future is that many analysts, who believed the price paid by Japan Post was high, also said it was “in line” with other deals in the global logistics industry. Bubbles occur in many sectors, and at different times, and there is good evidence to suggest the race to capture a slice of the growing global trends in online shopping are leading many to attribute new-
world-technology-like multiples to the old-world businesses like logistics. Without a genuinely earthshattering technological breakthrough in logistics, Amazon’s penchant for ‘‘reinvestment’’ of profits may need to continue for much longer than many investors are willing to bear. Meanwhile, Alibaba’s attempt to keep logistics at arm’s length may one day prove to be a vain attempt at privatising profits and socialising losses. Indeed, Alibaba has just announced its intention to invest a further 100 billion yuan ($19.4bn) over the next five years to strengthen its global logistics network, with the ultimate goal of fulfilling orders in China within 24 hours, and within 72 hours anywhere in the world. The reality is that getting a parcel from the virtual world to the real world requires cars, planes, boats and trucks. These are ex-
pensive, heavy and require maintenance — and as anyone with a boat will tell you, electronics and salt don’t mix. The economics of successful online shopping platforms are brilliant; what could be better than owning a virtual platform that brings shoppers and vendors together, clipping the ticket on every transaction? It’s a business that shares in all the revenue without ever having to make any of the products being sold. But those products do need to be delivered and if the poor economics of logistics sends those logistics companies to the wall, the online platform may need to do it themselves, in the process inheriting that very same economics.
Roger Montgomery is founder and chief investment officer of the Montgomery Fund. www.montinvest.com
