May 17, 2009 10:14 am

US gains top marks with China taking second spot

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Finally someone is paying attention to the plight of the small investor. Morningstar has issued a report for fund investors on the environment in 16 different markets.

“We’ve heard over the years about what it’s like for the institutional stock owner, but nobody really talks about that experience from the mutual fund side,” says John Rekenthaler, head of research at Morningstar. “The retail investor pretty much takes what he’s given.”

He hopes the report will spark a debate about how investors’ experience varies from country to country, ideally leading to improvements as countries aspire to match the highest standards.

The Chicago-based provider of fund information has spent the past year gathering, sorting and analysing data from its own industry experts in offices from Chicago to New Zealand about what fund investors have to deal with in markets across the globe.

On a grading scale from A to F, only the US market scored an A, while both Spain and New Zealand sat at the bottom with D grades. No market in the survey was deemed poor enough to warrant an F grade.

The report looked at six areas of interest: investor protection; transparency in prospectus and shareholder reports; transparency in sales practice and the media; fees and expenses; taxation; and distribution and choice.

Second after the US, with an overall B+, was China, which may come as a surprise to observers given how relatively immature the Chinese market is. Its score was dragged down by sales practices likely to bias investment advisers towards behaviour not in their clients’ best interest, as well as media coverage that fails to draw attention to fees or promote long-term investing.

China scores well on fees, however, despite a lack of interest from investors and the media in how much funds cost. This may be why it scores so highly overall, since the Morningstar methodology places great weight on fees and expenses.

“The highest score weightings are on the expense side – that reflects the importance I give it,” says Mr Rekenthaler. In the report, he explains this: “Fees and expenses eat away fund performance, and it is important to determine whether fees are reasonable and encourage the fund industry to lower them when they are not.”

Despite this, Morningstar notes Taiwan is the only country where investors make investment decisions based on the level of fund fees.

The report looks at front- end fees, although given the difficulty of establishing precise representative figures for fees actually paid (since these are frequently subject to negotiation), it gives a wide range, between 2.00 per cent and 3.99 per cent.

Total expense ratios are also calculated for three categories: equities, fixed income and money market funds.

The US has the only equity TERs below 1.0 per cent, while Canadian and Japanese investors are likely to be paying between 2.0 and 2.5 per cent of their equity fund assets away annually.

The methodology arrived at typical TER levels by using a dollar-weighted average, Mr Rekenthaler pointed out. Although this means the expenses look lower than is usually reported for each market (because niche funds are likely to be both smaller and to have higher expense ratios), it is more representative of the investors’ experience than the usual mean average, he explained.

Even though money market funds are cheaper everywhere than the other categories, except in Australia, where they are more expensive than fixed income funds, Mr Rekenthaler thinks they could be cheaper still.

“The cash fund is basically a cash cow for many of the fund houses,” he says. “The assumption is that nobody’s going to move their money because of the cost of a money market fund, and on the whole that’s been the case.”

The details of the report can be read online, including comparisons of each country’s performance in every category. Morningstar is hopeful industry participants and especially advisers will comment, both on the report’s findings and any missing areas of interest.

“We make no claims we’ve figured out everything we should be looking at, or how we should be looking at them,” Mr Rekenthaler told a London conference of investment advisers, inviting them to offer feedback. The immediate response was to suggest Morningstar should pay more attention to the split between active and passive investment, particularly in the light of the recent expansion of exchange traded funds.

Distribution and financial advice are other topics likely to get more attention in the future as the debate heats up. Morningstar’s objective is to make it easier for people to compare what they are getting with other markets and to encourage them to ask for change if they are not getting the best deal.

“I’m optimistic change will occur, because we’ve already seen change occur,” says Mr Rekenthaler. He cites recent changes in his home market, the US, as evidence that investor-led campaigns can make a difference. One instance was the requirement that funds reveal the name of the manager and his biography, in order to prevent companies from brushing over the departure of a lead manager to prevent outflows. “That was one of the few times that I can recall the voice of the direct consumers of the fund actually pushed the SEC to change a rule.”

Although he admits Morningstar cannot alone make the difference, he nevertheless has impressive ambitions for its role in change. “We want to be a prod, an advocate, a nag – a voice that’s articulating market forces that don’t get to speak up. We expect the gradual development of global best standards; we just want to speed up the process.”

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