Frydenberg faces up to mis-selling crisis

In a stunning development to start the new year, reporter John Kehoe has unearthed the corporate regulator’s classified advice to Treasurer Joshua Frydenberg imploring him to take action to prevent mis-selling crises across Australia’s funds management industry. The entire market is waiting with baited breath for the Treasurer’s response. 

Following a series of articles Kehoe published on these hazards in July 2019, Frydenberg asked the Australian Securities & Investments Commission (ASIC) to provide counsel on the subject. ASIC obliged with a raft of fresh analysis that confirmed stark warnings it had delivered the Coalition more than five years ago.

Kehoe’s freedom of information search forced ASIC to reveal that it had aggressively opposed the Coalition’s controversial attempts to roll-back the Future of Financial Advice (FOFA) laws that were legislated in 2012 to protect consumers against conflicted advice. With the benefit of hindsight in a post-Royal Commission world, the Coalition's indifference to consumer protections does not look especially smart.

You can read the full ASIC advice to government here, here, here and here.

The FOFA reforms were developed following repeated mis-selling scandals triggered by investment managers paying advisers, including stockbrokers and financial planners, chunky sales commissions to push their wares. Two key features of the laws are that advisers must always act in their clients’ best interests, and that they cannot accept conflicted kick-backs from fund managers to solicit money from their retail customers.

Importantly, the law distinguishes between companies paying commissions (known as “stamping fees”) to source debt and equity capital for their productive businesses, which is permitted, and fund managers paying advisers to promote speculative investment strategies, which is not.

Yet in 2014 the Coalition granted funds managers that list their products on ASX via a Listed Investment Company (LIC) or Listed Investment Trust (LIT) a surprising exemption from FOFA’s ban on these kick-backs.

This has led to a torrent of managers capitalising on the exemption through LICs and LITs with the sector more than doubling in size to over $52 billion as at 30 December 2019. Until Kehoe's story broke, a veritable tsunami of 20 to 30 global managers were reportedly preparing to further exploit this unique opportunity on the ASX in early 2020.

Many of these products have been complex hedge funds and levered junk bond funds run by managers that have not previously raised money from local punters.

In an internal ASIC email this year the regulator explained that "in December 2013 ASIC wrote to Treasury again opposing the expansion of the [LIC/LIT] carve-out ”. At that time ASIC advised Treasury that “broadening the exemption will expand the scope for conflicted advice and corresponding consumer detriment”. “From a consumer protection perspective, we do not see any policy rationale for this distinction."

ASIC was “concerned that any broadening of the exemption will lead to arguments by other industry sectors that they have been put at a competitive disadvantage by the uneven playing field that the exemption creates”. It concluded that “subsequent relaxing of the FOFA reforms will inevitably lead to consumer detriment”.

This competitive asymmetry has played out: whereas FOFA-compliant unlisted managed funds and exchange traded funds cannot pay advisers sales bonuses, LICs and LITs can.

Following Frydenberg’s July 2019 request for updated advice, ASIC quantitatively reviewed all the LICs and LITs that have come to market since the Coalition's exemption. In unusually hard-hitting language, ASIC concluded that "it is hard, on the historical data available, to justify maintaining the stamping fee exemption from conflicted remuneration for these products”.

Internal ASIC correspondence went further, questioning the basis on which advisers were satisfying their best interests duties to clients when recommending these products. "The poor performance of the majority of these funds don't justify the fee structure generally and it makes me question any advice to go into these products, particularly at issuance stage," an ASIC senior specialist wrote to colleagues.

Managers regard LICs and LITs as especially attractive because they carry very high fees and provide permanent capital that cannot be redeemed, which is why they often subsequently trade at a discount to their net tangible assets (NTA). If the consumer wants to get out, they cannot force the manager to sell the underlying assets—they have to rather find a buyer for their shares or units.

ASIC’s research showed that LICs and LITs listed since 2014 had massively underperformed both the wider market and cheaper exchange traded funds. ASIC also documented substantial relative outperformance from LICs and LITs that did not pay conflicted sales commissions.

Across the 42 products that paid commissions, the average since inception return was -7.3 per cent compared to a positive 3.0 per cent return for products that did not pay commissions. ASIC also found that LICs and LITs that pay commissions traded on average at a -10.9 per cent discount to NTA. Both the poor performance and the discount to NTA increased as the selling commission rose, according to ASIC.

The Financial Review’s analysis confirms these findings for the 2019 year. Across all LICs and LITs listed on the ASX, which covers 121 products, 79 per cent traded at a discount to NTA as at December 31, 2019. The average discount across all products was 9.7 per cent.

Over the 2019 calendar year, the average Australian equities LIC/LIT underperformed the All Ordinaries Accumulation Index by an enormous 9.1 per cent. The average global equities LIC or LIT underperformed the MSCI ex Australia world index by an even larger 12 per cent over the same period.