Holly Cook: In Morningstar’s endeavour to illuminate investing we take a look every two years at how the fund investor experiences investing. In the latest report, the UK got a B-. Joining me today to discuss what that grade is all about is Morningstar’s John Rekenthaler.
John, thanks very much for joining me.
John Rekenthaler: Sure, Holly.
Cook: So can you explain to us what actually goes into the fund report and why has the UK got a B-?
Rekenthaler: I’ll start with the B-part, the latter part of your question first. That's an average score. So we have a little bit of grade inflation, but not as much as many universities now. There are nine of the 24 countries have a B- score, so it’s an absolute median score. It’s an A to an F range; nobody gets an F for overall score. The US has the top score of an A, and it’s the only A. In the UK, it’s right there in the middle with six other European countries, plus India and China as well, which get there in quite a different fashion. So that’s to answer the second part of your question.
To answer the first part of your question, what goes in there? A lot of things. This is a measure of fund investor experiences, so it’s not a measure of the fund industry specifically. That’s a common misconception. People say, John, where’s Luxembourg, as there’s so many Luxembourg funds. Yes, but there are not very many Luxembourg investors, are there? So we’re looking at each country and saying, what’s the experience of the investor. Part of the experience of the investor are the locally domiciled funds that are available to them. So part of this is a score on the fund industry, but it’s also the tax regime, the regulation, the government regulation.
We look at sales in media, how funds are sold in the country, how the media talk about funds, so a wide variety of things. Most of this is outside of the direct control of a fund investor, other than through their behaviour they can change these things. If they gravitate towards lower-cost funds and they buy lower-cost funds, then the score for the fees and expenses in that country, for example, will go down. But really there are lots of parties involved, and this document is meant to reach and it does reach people in fund industry, people in governments, a lot of areas.
Cook: So the UK overall is kind of doing okay with a B-. So let’s look at the kind of positive side: what are the strengths for fund investors?
Rekenthaler: You’re doing okay, and realise that Europe in general with UCITs and common regulations and reduced boundaries, at least compared to how we look at things here in the States, where, for example, in the US you can’t buy a fund that’s not domiciled in the US and following US regulations. So Europe has a commonality that tends to keep the countries relatively similarly, and the United Kingdom is a part of that; it is a part of Europe, despite the Channel being there, still a part of Europe. One thing that the United Kingdom does very well is sales and media. So compared to other European countries, the media in the United Kingdom, we think, is quite good at talking about the importance of owning funds for the long-term as opposed to promoting short-term performance, and talking about the importance of fees and expenses, and setting that into context for investors. So we think investors are served quite well by the English media when we look at the, say, other European countries or the rest of the globe. And the sales practices are pretty good too. There tends to be an open distribution as opposed to in many countries you go to a bank or some institution, and it’s pretty much their homegrown funds that are available. So it's an open system and there are some other aspects with sales practices that tend to be more disclosure-oriented than occurs elsewhere.
Cook: So a UK fund investor is being served quite well by the kind of sales, marketing and the media side. Where do we fall short? Why are we not up there with America with an A?
Rekenthaler: Well, fees and expenses are a huge issue. I don't have the figures exactly, but roughly speaking I think on an asset-weighted basis, the UK investor pays something like 1.7% per year in expense ratio for an equity mutual fund. Well, that’s under 1% in the US, it’s about 0.9%. So that’s almost – just almost half of that. So that’s a very large amount when you're talking almost a percentage point a year in fees and expenses difference.
Or if you're comparing specifically to the US, as you were in your question, as good as – the disclosure tends to be pretty good in the United Kingdom regarding what's in the funds and so forth. But it's hard to – nobody matches the US disclosure, where we get information about how the portfolio managers are compensated. So what's the compensation structure, how much do they own in the mutual funds that they have, etc. Every time a portfolio manager leaves, the investor is notified and the prospectus is stickered and so forth. So there’s an information flow that the United Kingdom is not yet best practices. It’s not bad. There are countries that are out there that are worse. There are some countries where you can’t even get your portfolio holdings and know what’s in your funds. You’re a shareholder, you own the fund, but they won’t tell you what you own. So you’re better than that.
Cook: Okay. So we’re paying kind of almost double what the American investor might pay for a similar sort of fund. But I think another kind of place where we come up short is the transparency, right? You mentioned regulation earlier. I mean, in the UK, there is a lot that’s been happening in terms of trying to improve transparency. The government has introduced this Retail Distribution Review. But if that’s still a weak spot, what do we need to do to move forward with that?
Rekenthaler: Ironically, we actually scored you better, the United Kingdom better, under the old system of a simplified prospectus that followed a question-and-answer format and that we found it was actually easier to follow than the new KIID document that’s come up. So, in our view, that was not a step forward, as well the new document does not have a monetary illustration of the effect of fund expenses. So before you had it in pounds if you put in this size of an investment in a fund, how much would you pay, not just in percentage terms, which people find in percentage terms difficult to interpret and they all look so small; 1% seems so small, but you see that translated into pounds and it’s whatever the cost might be, £50 or £100 or depends on the size of your investment; £200 per year, you realise the effect of that. That used to be in the simplified prospectus, but is not there now. So we say bring – maybe go back, set the time back. There are some good things about the new [KIID] document, but to bring back some of the benefits of the old simplified prospectus would help. That’s a concrete suggestion for you.
Cook: Okay. So simplifying the information provided to investors is, obviously, important in terms of making sure that the investor completely understands what it is they’re buying.
Rekenthaler: That’s right.
Cook: But how do we actually go about kind of making these improvements? Is it down to the fund companies to make the changes, or should the end investor be kind of voting with their feet somehow? How do we actually make it happen?
Rekenthaler: Well, the disclosure items that I discussed, they come out in discussion between the fund industry and the regulators, because that’s a standard practice and they’re the ones that are having a discussion that end up with the document. As I mentioned before with fees, clearly, the fund investor can do that. You have funds that have a wide variety of costs. What happened in the States, for example, was if you look back 20 years ago in the States, the costs were a lot closer to where the United Kingdom is now for investors than they are in 2013. US investors made strong decision collectively, now obviously they weren’t talking to each other, but they kind of got there, to move toward much lower cost funds, and you’ve seen cash outflows from expensive funds over the last decade and strong inflows into the cheapest funds. That’s one where success begets success from the investor’s point of view.
As fund companies are rewarded for putting out lower cost funds and those companies are receiving assets, new funds come to the marketplace that are cheap as well and just drives down prices. So that’s something that clearly that investors can take into consideration. With disclosure practices, since they tend to be mostly similar across different fund families and with different funds, that’s something that is harder for an investor to factor. Of course, they can always write letters or engage in a discussion, but they can’t do that through a purchaser or sale decision.
Cook: So the simplest thing then for the end investor is if you seek out those lower cost funds, that’s a clear message to the fund company. That’s what you are looking for, the lowest cost funds that can help you get the best returns that you can possibly get.
Rekenthaler: Yes. Another thing that we look at is would be taxes and the tax burden. Believe it or not, actually the United Kingdom does pretty well on that, actually better than the US.
Cook: We would never think that.
Rekenthaler: I am sure you wouldn’t think that, but for example, you don’t pay capital gains on a fund until you sell the fund, where in the US you’ll pay capital gains on a fund as you hold it, because the fund will make capital gains distributions often. So that’s – and there are other aspects actually where the UK does reasonably well – but of course, that’s another example where people do have an effect in a small way, because they can vote for candidates that support lower tax regimes for mutual funds. We’re not making a political statement in this. We’re saying as a mutual fund investor or shareholder, if you pay lower taxes, you take home more of your investment ultimately, and it’s a better experience from a fund investor’s perspective if you pay lower taxes. So that’s something that’s clearly not – that’s not what fund companies can control. That comes out of government policy, and a number of these do come out of government policies.
Cook: So if were to kind of sum up two years’ worth of work into one line, is it fair to say that we are kind of doing okay, but could try harder for the UK?
Rekenthaler: Yeah, I think that’s fair. Doing okay – you may be trying harder, but you could do better. We can’t gauge how hard you’re trying, but yes, you do want to right it. It’s worth noting that no country, as I said, flunks in this test. When you look at mutual fund investing as opposed to hedge fund investing or many other financial experiences, it really is a pretty positive story globally. There are almost no frauds. It’s a well-regulated playing field; disclosure – even the bad disclosure is good disclosure compared to what you get often, say, in the insurance industry or many other industries. So it’s a good industry overall, and it’s revealing. I mean, B- is not that bad a grade, because we try to be reasonably tough. So let’s take consolation in that, but there are still a number of things that can be done to be global best practices.
Cook: Okay. Well, thanks very much for summing that up for us, John, we hope that we’ll see some improvements in two years’ time when we do the report again.
Rekenthaler: Sure. Bring me out to London and I’ll tell you all about it.
Cook: Will do. Thanks very much. For Morningstar, I’m Holly Cook. Thanks for watching.
