From my experience, most investors are very trusting of whoever is advising them about where to place their money for a long term return. While a growing number of such investments are placed into international UCITs the majority of such monies are placed in the unit funds of either life assurance companies or unit trusts operated by private bankers or stockbrokers.
In reaching a decision to invest in any fund, investors normally make decisions on “gut feeling” as very few have an in-depth knowledge of investment markets, never mind investment products. Typically such gut feeling comes about because of their reliance on their advisor’s recommendation as well as the positive impression that the investment’s marketing material leaves on them.
Nonetheless, there are a number of key information pieces that most investors either gloss over because they don’t read the marketing material or don’t fully appreciate the significance of the required warnings inserted on the fund factsheets or advisor’s suitability letters. Quite often, the full potential impact of these only becomes apparent to the client when they experience a financial loss. Clients need to realise that risk is present everywhere, even with bank deposits as well as the more extreme volatility that can attach to equities. While the Global Financial Crisis brought this home, the lessons learned by many investors and quite a lot of advisors seem to have faded into the distance.
There is no free lunch for investors, yet many investment companies make a virtue out of marketing investment allocations of greater than 100% of the original investor capital. What is often overlooked by clients and advisors alike is that the “bonus” investment has to be recouped by the investment company and is done by increasing the annual management charge to counter the increased allocation. What is then forgotten is that these higher charges can continue for the lifetime of the investment and not just an initial period. The product can therefore be a relatively expensive offering instead of being a “bargain” investment.
Annual management charges are not the only expenses incurred by investors as these charges are merely the compensation payment to the fund manager. Other costs in buying and selling assets such as stockbroker fees, estate agent fees and government stamp duty are incurred. The more that such trading activity occurs, the more such costs are accumulated. This is more so if the fund manager makes a bad call on buying or selling an asset. These costs aren’t obvious to the investor but end up being absorbed into the final unit price of the fund and so get reflected in the fund performance. The more costs, the less investment growth.
There is now a growing international trend to invest using “Passive” funds which track the broad market indices and require very little fund manager involvement. Accordingly, such funds tend to be considerably cheaper especially if international indexed fund manager offerings are used. Indeed, some of these international funds have their charging levels as low as 15% of those charged by the “Active” fund managers. When markets fall, the full impact of these management charge savings become more obvious, so the cost structure of passive funds tends to be more beneficial to investors.
With regard to market risk, investment managers are now required to grade their funds before they promote them to the public. These risk scores – 1 represents the lowest risk type while a 7 represents the most risky – must be advised in their key investment information documents. The scores themselves are based on an analysis of the volatility of each fund using the weekly past prices of the preceding 5 years. What is not usually fully appreciated is the scale of a potential fall in value of each individual fund within each risk category. For a middle grade score of 4, which is where many managed funds are found, such rated funds could suffer a short term fall in value of up to 20%. International equity funds, which tend to be rated as a 6, could experience falls in value as high as 50%.
Tracker funds have been quite popular among some lower risk investors who still want to dip their toes into investment while protecting their capital. Quite often they are promoted as costless investment offerings. This is not so. Apart from the lack of access to investor capital for the term, usually 5 or 6 years, what is not fully understood is the erosive effect of inflation on a simple return of money. For example, an annual inflation rate of 2% results in a decrease in purchasing power of 12.6% over a 6 year period. Added to this is that many such trackers now have the potential of suffering heavy losses, apart from the inflation aspect, if the underlying tracked element falls below certain prices at the precise date that the tracker product matures or possibly during the term. It is not unusual for some tracker funds to have a potential to lose up to 60% loss occurring on what has traditionally been perceived as a no risk product!
And finally, tax. All investment fund gains are taxable but most performance data shown on marketing brochures tends to show the gross return. Personal taxation on performance data tends to be excluded as the same fund can be used for both personal or pension needs. Where personal investment occurs any Irish unit fund is subject to Exit Tax of 41% on any growth on encashment or if encashment hasn’t occurred before eight years then the tax is deducted from such growth by the institution on the eight year anniversary.
All in all, investors need to fully understand the risks, costs, tax issues and time line associated with what happens to their money and not to take marketing speak at face value. Too often the lack of focus on the important issues results in becoming aware of financial losses at a time when such losses can be very difficult to bear. The bottom line is – investor beware!