The problem with managed funds

PORTFOLIO POINT: Investors in managed funds in continual or steep decline should redeem their units.

Last month Macquarie Group announced it would close at least three of its managed funds. This article explores some of the consequences and suggests ways to improve your portfolio to minimise losses.

It’s always upsetting to read of investors losing money, and it was no different when Macquarie Group announced the closure of at least three of its funds last month: Macquarie Property Securities Trust, Macquarie Balanced Fund and Macquarie Small Companies Growth Trust. However, it does give the rest of the investment community the opportunity to examine the consequences and look at ways to improve portfolios to minimise losses.

Macquarie sent letters to clients explaining the situation:

“Due to the increasing investor redemptions the reduced size of the fund is expected to lead to increased costs and potentially lower returns to unit holders. Therefore we formed the view it is in the best interests of unit holders to terminate the fund”.

The comment should act as a warning to managed fund investors that you don’t want to be the last one to turn out the lights in a managed fund. So, investors should keep an eye on the size of the fund and those funds in continual or steep decline should present a warning to investors to think about redeeming the units before the managers decide to terminate the fund.

Liquidity of the underlying investments in a managed fund is the key. How easily or quickly can the investments be sold without loss of value?

I think it is interesting that one of the Macquarie funds to be terminated was a properties securities trust. Property can have a particularly nasty sting if you need to sell quickly (especially if it holds direct property or if the managed funds holds a disproportionately high share of a single listed property company) to satisfy an increase in redemption requests quite possibly due to under-performance. Think about Queensland tropical island resorts and the impact of the high Australian dollar or US residential property or Irish commercial property. These markets have simply plummeted. Forced sellers in these markets have been lucky if they could find buyers. Personally, I’d avoid property managed funds because of the possible illiquidity of the investments. Sure, the distributions might be attractive enough but does it compensate you sufficiently for that possible illiquidity or loss of capital?

Managed funds are good for investors with smaller portfolios. The Macquarie funds needed a minimum $20,000 to invest. Typically the minimum investment for managed funds ranges from $5,000, up to $50,000 for specialist bond funds. Problems with managed funds include:

• No control over choosing underlying investments and they can be tied to an index
• No control over when to take profits or losses to suit your own personal taxation requirements
• No say on when or if to terminate the fund
• Gains and losses are hidden behind a daily unit price
• Investors are exposed to the fund manager as well as the underlying investments

Some other points to note:
Size and type of investment matters – if you like the managed funds style of investment look for large, well-known managed fund companies. PIMCO is a large international competitor and its minimum investment for some retail funds is as low as $5,000. Blackrock is another fund I’d investigate. Choose individual funds that are large and assess the underlying liquidity of the investments.

Direct investment is the best option in my view. That way you have no exposure to the dynamics of a fund – the manager, the whims of other investors, nor the costs associated with a wind-up. Government bonds can be bought from as little as $1,000 and ASX-listed senior, subordinated debt and hybrids have no minimum transaction amounts.

If you want an exposure to property, there are companies that issue bonds such as Stockland, Mirvac and Westfield'”all that have known returns and sit high in the respective capital structures.

Table 1 below shows four property bonds available; three are available in $50,000 face value parcels. Mirvac, Stockland and Leighton bonds are all senior debt and fixed rate and are trading at a premium above their $100 issue price. Yield to maturity (YTM) ranges from 5.63% for Stockland through to 6% for Leightons. The running yields for all three bonds are higher, reflecting the high coupon payments, valuable in this declining rate environment.

The Genworth security is subordinated debt and offers a floating rate coupon with an attractive 7.88% YTM (based on current swap curves) and an 8.98% running yield. Genworth is an Australian mortgage insurer and, as such, is considered a “property play”.

Table 1:

Residential mortgage-backed securities (RMBS) might be another option where the underlying securities are mortgages and the pool of securities is divided into tranches (much the same as a corporate capital structure), where you can chose the most appropriate risk/ reward option.

Diversify, diversify, diversify. The key to protecting your capital is to spread your allocations across asset classes, sectors, companies, countries or currencies and of course risk.

Elizabeth Moran is director of education and fixed income research at FIIG Securities.