We generally prefer to rely on our own writers and advisers for content for this newsletter, however, we thought Christopher Joye’s recent piece on how broking and advisory firms around the country are flaunting commission bans was particularly relevant following the Royal Commission.
We have outlined on many occasions our views and a detailed analysis as to why so many companies and managers have been flooding the market with listed investment companies and exchange traded funds; they provide a guarantee amount of capital to invest and on which to charge fees. However, we have spent little time on analysing why these are so popular with the major stock broking houses and investment newsletters. Christopher Joye’s article takes a deep look into the sector and why you should question why you have been recommended the latest IPO. As always, where Wattle Partners cannot avoid the receipt of this type of commission, it is refunded to clients.
Boiler rooms’ are back as listed investment companies raise $6b
Fund managers have figured out how to circumvent the vital Future of Financial Advice (FOFA) consumer protection laws to pay gigantic sales commissions worth more than $150 million to brokers and advisers despite FOFA being implemented to prevent precisely this practice. Parliament originally introduced the FOFA reforms to stop product manufacturers, mainly fund managers, paying conflicted sales commissions to advisers and/or brokers – or anyone with a financial services licence – providing advice to retail investors. FOFA does not apply to wholesale (as opposed to retail) investors, nor to any normal business issuing shares, senior bonds, subordinated bonds or hybrids (preferred equity) to raise money to fund their operations. In these cases, conflicted commissions are permitted.
When these laws were introduced in 2012, they applied to all investment entities, including listed and unlisted funds and investment companies. In 2014, however, sustained industry lobbying convinced politicians to exempt listed investment companies and trusts from FOFA’s all-important reach. Fund managers are now simply shifting their capital raising efforts on to the ASX to allow them to side-step FOFA completely. As a consequence, there has been a tsunami of new listed investment companies (LICs) and listed investment trusts (LITs) launched since 2017, raising more than $6 billion for fund managers who have paid brokers/advisers enormous sales commissions of up to 3 per cent of the value of the capital contributed by mums and dads. This includes big names such as Wilson Asset Management, Magellan, Platinum, VGI, and many others.
In dollar terms, fund managers have paid more than $150 million in conflicted commissions to get brokers/advisers to push their products to retail investors, often in incredibly short time frames. For the vast majority of fund managers rushing to exploit this huge loophole, there is zero chance they could secure this volume of capital as quickly as they can on the ASX through normal FOFA-compliant channels.
And there is a real risk that advisers and brokers incentivised by large sales commissions promote complex strategies to retail investors who do not properly understand the products. Take the example last year of the leveraged “long short” equity hedge fund strategy managed by L1. Historically a product that had been mainly used by sophisticated high net worths and institutions, L1 appointed no less than 13 different brokers/advisers to spruik an ASX-listed investment company offering its strategy to punters.
The six joint lead managers promoting the L1 LIC earned a management fee of 1.25 per cent plus a selling fee of 1.5 per cent, for total commissions of 2.75 per cent. In total, L1 paid at least $37 million in fees to the brokers/advisers flogging their hedge fund to retail investors, which would not be possible under FOFA. After a one-month marketing campaign, L1 raised $1.35 billion for a strategy that could be leveraged up to three times the portfolio’s net asset value. That is a seriously racy hedge fund. Through FOFA-compliant channels it would normally take five to 10 years to source this volume of capital assuming you could maintain its returns. Unfortunately, L1 could not. Within eight months of listing on the ASX, the L1 product had lost 36 per cent of the value of its clients’ money (or almost $500 million). While there is no suggestion that there was any mis-selling in this transaction, that is always the worry with conflicted remuneration.
Beyond equity hedge funds, a second fad has been for fund managers to use enormous sales commissions to quickly raise large amounts of money for illiquid, risky and often complex fixed-income strategies with extraordinarily expensive fees as high as 1.5 per cent annually (similar to the sorts of fees investors pay hedge funds). I myself have been approached by players in this space wanting us to launch an LIC or LIT of this kind. Since the end of 2017, there have been billions raised on the ASX for high-yield funds, direct-loan funds, and mortgage-backed securities portfolios with many of these assets having no credit rating or being rated below investment grade with questionable or no underlying liquidity.
Creating the appearance of liquidity by listing a portfolio of illiquid assets on the ASX and flogging them to retail investors by promising returns of 8 per cent to 10 per cent annually (while slugging them with 1.5 per cent annual fees) seems to be a recipe for disaster if these assets start defaulting.
It is one thing asking mums and dads to buy the subordinated bonds and hybrids issued by highly rated banks that they all know well and transact with daily, and which have decades of proven credit risk-management expertise. It is quite another flogging them illiquid loans to companies they have never heard of and that do not have the benefit of deposit guarantees, RBA emergency liquidity backstops, and APRA supervision.
Without paying conflicted sales commissions, these fund managers would not raise a cent on the ASX and it would take years to originate the same quantum of capital through FOFA-compliant channels (on the proviso their returns persisted over the period in question).
A second problem with LICs/LITs is that they are closed, which means investors cannot redeem their shares/units. They are therefore providing fund managers with incredibly valuable permanent capital carrying high fees, which is why they have been so eager to exploit the FOFA loophole for listed products. To get out, investors need to find someone willing to buy the shares/units, which results in LICs/LITs often trading materially away from the portfolio’s actual net asset value.
This is a new source of risk for retail punters that they do not face with traditional unlisted managed funds or listed ETFs where you can create and redeem shares/units. It would be surprising if the Australian Securities and Investment Commission is not already investigating this dysfunction, and if Labor in particular, which historically has been stronger than the Liberals on FOFA, does not close the loophole.