Tuesday 09 September 2014 by FIIG Securities FIIG Securities Legacy

Is your managed fund hiding something?

Two recent events brought home how powerless investors in managed funds are when danger looms in the financial markets

First, an advisor client sent me an email expressing a range of concerns about the bond market including the risk of a meltdown in emerging market bonds caused by Argentina, signs of stress on the high yield bond market and an alert he’d been sent by a fund manager that it was increasing cash holdings due to its concerns about a potential credit event. 

Argentina, in case you missed it, defaulted on some of its debt payments recently which as a consequence sent the prices of emerging market bonds and shares lower. Fortunately, the event had no impact on the domestic bond or share markets. However, a managed fund investor will not know what impact it had on their investment because they will not know if the managed fund owns Argentinean bonds or shares. 

The stress on the high yield bond market the advisor was referring to was in relation to US dollar bonds. The US high yield market makes up over 20 per cent of the whole US corporate bond market.

Incidentally, the stress in the US high yield market has not spilled over into Australia. We haven’t in see any “stress” on any of the high yield bonds we trade. Interest rates must rise or the credit quality decline and potential for default rise for high yield bonds in the domestic market to be significantly impacted.

Rising interest rates will impact all asset classes but the big question remains, when? In the meantime current high yield bond issues soldier on towards maturity reducing terms and the impact on any rate rises.

It also turned out that the fund manager note received by the advisor referred to its managed equity funds not its bond funds. The note explained they were moving from a 5 per cent cash holding and increasing it to 10 per cent to reduce risk.

Like other managed funds, the equity fund only discloses the top 10 holdings. In this particular AUD global equity fund these top 10 holdings made up around 50 per cent of the portfolio, although the fund also disclosed a 19 per cent exposure to emerging markets and 20 per cent to the rest of the world.

Here’s the crux, investors don’t know what’s in the rest of the portfolio, so how can they assess the potential risk of say, a default by Argentina or any other event?

I’d be fairly happy if I had invested in global equity funds that are taking some of the risk off the table and increasing their weighting to cash. This will help them fund redemptions and help insulate the funds from losses if a much talked about correction eventuates.

But the advisor’s experience illustrates the central problem of managed funds: they have none of the certainty of direct investment. If there’s a big correction these funds could be frozen or wound up and investors could lose money.

Interestingly, the questions from the advisor coincided with a second event which illustrated problems with managed fund investing. In mid-August four of the van Eyk Blueprint series managed funds were wound up because of a “mysterious $31m illiquid investment”. The news sent investors rushing to redeem van Eyk funds and this week the first steps were taken to wind up nine of the remaining ten funds.

Investing direct and understanding the risks will help protect your capital. Direct investment in Australian dollar investment grade bonds is a much lower risk strategy than managed funds that do not disclose all investments.