The trouble with guaranteed funds

Fund houses offering guaranteed products create a conflict between revenue and investor education.

In the wake of market instability, the rage among fund management houses in Hong Kong has been to roll out guaranteed funds. May was a banner month for unit trusts. Total intake from Hong Kong investors totalled $1.3 billion, and guaranteed funds attracted $957 million of that, or about 71%, according to the Hong Kong Investment Funds Association (HKIFA).

Not only is this the highest amount guaranteed funds had ever received in any one month, it is the highest amount received by any category of investment product. And that has been the case all year. Guaranteed funds have gained $1.47 billion in net inflows from Hong Kong investors, or 85% of the industry’s total.

The HKIFA cites the falling interest rate environment as the biggest reason. The cuts have left bank depositors with a mere 2% savings rate. "For many depositors who have never invested before and are relatively risk-averse, guaranteed funds probably are viewed as a possible investment vehicle," reports the association.

One marketer, recently unveiling a new guaranteed fund, added another target customer: the speculator who has recently been burned but wants to "sleep at night and still catch the rebound".

Guaranteed funds come in many colours but share a basic premise: up to 90% of contributions are invested in fixed-income instruments, most commonly zero-coupon bonds, and the rest is invested in an aggressive fund. Recent cases in Hong Kong have pitched 'safe' ways to invest in high-yield bond funds, global tech funds and Asian equity index funds. The fund manager guarantees the principle back (or sometimes a tad extra), plus whatever upside materializes from the ratio of assets invested in the aggressive tranche. Some funds even calculate any losses suffered by the aggressive tranche as zero so it doesn't weigh down that portion's return.

Selling to the meek and the reckless is good business for fund management companies these days, but it may not be such a great idea in the long run.

These funds are pitched as safe and generous, and they are indeed safe. But with management fees anywhere from 1.50-2.25%, they are far from generous. Even without loads and redemption fees, 1.50% would be considered highway robbery for a traditional actively managed fund. An equities index fund management fee is 80 basis points.

Yes, there is the guarantee, but if more than half of an investment is going toward AAA-rated, zero-coupon bonds, investors would be better off putting most of their assets into a cheap bond fund and a smaller amount into that Korea fund. Paying someone more than 2% on a compound annual basis to put 80% of your dough into a bond fund is fantastic business for the fund manager – and a lousy deal for the investor.

There are of course instances where guaranteed funds play a role, depending on the investor’s risk profile. Someone close to retirement, for example, should consider this product. Fund managers can also make the case that it is a useful way to introduce novices to mutual funds.

But is there $1 billion’s worth of such investors to be found in one month alone? Of course not. Fund managers are playing off of punters’ insecurities.

It’s a free country, and this is great business for the firms’ shareholders. But consider this: why has the mutual fund industry been such a non-starter in Hong Kong, at least until the arrival of the Mandatory Provident Fund (MPF) scheme? Fund managers are always complaining about how Hong Kong’s retail and even institutional environment is plagued by speculators. The stock market is frequently compared to the Happy Valley horse races. The concept of asset gathering has but a weak toehold.

The number-one priority, we have heard ad nauseum from the industry, is investor education. Only then can the fund business here mature and grow.

Well, some firms are showing their true colours, and chucking education when there is a quick buck to be made. Many of the new guaranteed funds come from MPF service providers. They should take a look at their long-term priorities and teach investors about dollar-cost averaging, instead of trying to soothe speculators looking to time an entry back into the market. As an MPF culture takes hold, more investors will catch on. Some houses will have earned their trust, and others will have not.

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