Unwrapping wrap funds, unit trusts and funds of funds

The Australian and South African financial sectors have a lot in common, not least the number of South African expats over there.

And both countries use the rather quaint term unit trusts for mutual funds, which is also used in other Commonwealth countries such as Fiji.

But it is a mystery to me that while South Africa now has close to 2,000 unit trusts and growing, in Australia this has shrunk to 200 or less, in terms of what they call public offer unit trusts.

As an occasional visitor Down Under, I would hesitate to comment on the detail. But it does show that industry consolidation can happen — and can happen rapidly.

In South Africa it is tax efficient for brokers to offer a portfolio of unit trusts in a fund of funds wrapper. Prior to the introduction of capital gains tax in October 2001 there was a plethora of wrap funds which combined unit trusts for investors. Most of these were closed after the introduction of CGT.

Quite simply, every time units were sold in a wrap fund it incurred CGT. But when the underlying unit trusts are sold within a fund of funds it is CGT-exempt.

Funds of funds are not popular in Australia as they don’t have the same tax advantages as they do in South Africa. Nor are multi-asset (balanced) funds, as there is no equivalent of South Africa’s Regulation 28 of the Pension Funds Act. Half the assets in the local industry are in Regulation 28 compliant funds; in Australia, single-asset class funds still dominate.

It is quite puzzling that, in spite of their undoubted tax disadvantages, wrap funds have come back in South Africa. They aren’t called that any more; they are euphemistically called “model portfolios” these days. The wrap fund managers of the 1990s have re-emerged as the discretionary fund managers (DFMs) of today, though they are not necessarily the same people.

DFM is a broad term. The dominant DFMs in the local market support the large bank broker forces such as Standard Bank Financial Consultants and Nedbank Financial Planning. Others are designed to extend an institutional multimanager’s distribution into the independent market, such as Alexforbes’s Investment Solutions.

This adds another layer of fees in the increasingly expensive retail investment food chain. There is finally some transparency as data providers such as Citywire roll out managed portfolio surveys. But it is too soon to say if DFMs add value to the retail investor.

Looking back, it often makes most sense not to overengineer portfolios. The early wrap funds were very granular, choosing small cap, financials and resources managers. But these funds have little support these days.

As an elected trustee of a pension fund, I always believe in keeping it simple. We stuck with quite a predictable equal split between the big gorilla balanced managers, Coronation, Allan Gray and Investec (now Ninety One), known in the trade as the CIA (the CNA these days presumably).

The fund had paid school fees before I was elected, choosing BOE when it was a flavour of the month manager, but the keep-it-simple philosophy worked on the whole.

The default option if we were unhappy with our underlying pension fund portfolio was the Investment Solutions (now Alexforbes) Performer Fund.

It has been a huge commercial success, with more than R220bn under management. It has had strong distribution through the Alexforbes retirement fund consultants, its de facto agency force. But it has also proved to be a strong product, adding alpha quite consistently by investing in the balanced funds of half a dozen top balanced managers.

Australia has seen a much more rapid move to index funds than South Africa because fewer managers have been able to add alpha, or at least not as consistently as South Africa’s big gorillas. The Australian press doesn’t tend to build up cult managers in any case. But looking back 25 years from now, index funds must grow in South Africa.

We are moving away from the era of the cult manager — bearing in mind that Warren Buffett does not manage mutual funds: Berkshire Hathaway is a financial and industrial conglomerate.

The days of Peter Lynch and Bill Miller, not to mention Allan Gray himself, are over. Cult managers such as Terry Smith, Nick Train and Neil Woodford have proved to have feet of clay. The Emperor has no clothes.

For now, I believe there is genuine skill in the South African market from the likes of Gail Daniel and Clyde Rossouw at Ninety One, Karl Leinberger at Coronation and Duncan Artus at Allan Gray — and their respective teams. I have interviewed them all enough to see that they don’t peddle nonsense.

At any given point someone else might be doing better, and no doubt DFMs will market themselves as choosing tomorrow’s winners. The CIA firms are employers of choice who can pick the brightest people coming into fund management.

But I would be reluctant to take a bet that over the next 20 years the old CIA will beat an appropriate mix of indices — which would be about 35% invested in global markets.

There is a great deal of survivorship bias in investments. Many people under 40 won’t remember UAL or BOE or even how to pronounce Syfrets. But I would certainly take the view that the CIA will still be around in my lifetime.

As listed companies, Ninety One and Coronation Fund Managers are always under the threat of takeover, but hostile takeovers rarely work. And in both cases, management has enough of a direct stake to keep most predators at bay or at least make any takeover extremely messy.

Allan Gray, even after the death of its powerful founder, has secure shareholding through the foundations which the Gray family has set up. The firm has survived short-term bouts of underperformance, and no doubt will do so again — but investors know that kind of relative volatility is part of the Allan Gray brand.

Its challenge will be that as a large business in its own right — with more than 1,800 staff — Allan Gray doesn’t become a corporate or an institution. Will it remain nimble? I think so, as the investment team itself is still tight, and remains autonomous, so Allan Gray should navigate any troubled waters.

I would certainly be less confident about the second and third tier managers out there, though there is plenty of talent around. I have money (indirectly through funds of funds) with Truffle and Laurium. And when it comes specialist fixed income — a vital component post-retirement of a living annuity — I have confidence in some smaller shops such as Prescient (which isn’t that small any more), Terebinth and Matrix.

Many funds in the industry are what used to be called broker funds. Financial advisers or networks of advisers offer a fund of funds under their own brand. They often outsource the manager selection to another party — in the case of Sanlam, this could be under various brands such as Graviton and Glacier Invest.

There are some reputable standalone DFMs such as PortfolioMetrix, Analytics and Morningstar — the Morningstar DFM is part of the same group as the Morningstar data provider, but it is run independently.

Each client needs to determine whether these organisations are adding value. If they aren’t beating both a passive balanced benchmark and a default CIA blend at least half the time, then what value are they adding?

To show that they are adding value, DFMs often avoid predictable choices and favour the second tier; Truffle, Fairtree and Laurium certainly owe much of their growth to DFMs. For now these firms look like good choices with experienced fund managers and good track records — and none of these firms is a one or two-man band any more.

The big weakness of many DFMs is that they still see their job as picking the right asset manager and would consider choosing an index fund to be a “cop-out”. But index funds, as a source of cheap Beta, can play a vital role in the portfolio construction process.

There is bound to be continued pressure on fees, which will accelerate the pressure towards the index — especially in areas in which local managers don’t have much expertise, such as global equities. So expect an increase in the number of unit trusts in the short term as index funds are rolled out.