Skim, scheme, scam and some Greek letters

It's a conundrum. You need to save. You must save if you're an average battling Ozzie employee because the government has made it mandatory that your employer put 9% of your wages into a superannuation fund. Not into your account, or even an account that you can manage yourself. Nope, into a fund that employs managers to do that for you. So you are their employer. But they set their own wages, and they do so for their own benefit, not yours. Alan Kohler tells us how and shows us the alpha and the omega of the industry.

THE business of collecting money from the public and investing it in companies so they can employ people who can provide them with their savings so they can employ people - the cycle that might be described as capitalism - has undergone a revolution that deserves far more examination than it gets.

Warren Buffett had a go at it in his 2006 letter to Berkshire Hathaway shareholders last week, when he asked us to imagine that all American corporations were owned by a single family, called the Gotrocks.

He explained that the Gotrocks had been going along fine until they started trying to outdo each other. To do that they each employed helpers, called fund managers, and then consultants to choose the helpers, and then still more consultants to choose the consultants. Their returns naturally went down as each layer of helpers took a cut. The Gotrocks plunged into despair as their returns fell, but could only employ still more helpers fix the problem, who of course simply took another cut.

Buffett said he thought frictional costs, as he called this, may well amount to 20 per cent of the earnings of American businesses, which is another way of saying that investors are only getting 80 per cent of what they should.

He concluded: "Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac's talents didn't extend to investing: he lost a bundle in the South Sea Bubble, explaining later, 'I can calculate the movement of the stars, but not the madness of men.' If he had not been traumatised by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: for investors as a whole, returns decrease as motion increases."

The Australian Gotrocks have at least three layers of helpers, and that doesn't include the company managers who are scooping off some of the biggest slices of all. The skim here is also about 20 per cent, although as stockmarket returns inevitably decline in the immediate future and the skim does not, that percentage will rise.

A system has now developed that involves financial advisers channelling money through platforms and master funds into wholesale fund managers who in turn partly invest in other funds called infrastructure trusts, which are paid extra performance fees [simply] for doing their job.

The core of the system are the master funds, also known as platforms and wraps: they're all the same - basically computer programs that administer a variety of investment vehicles and provide simplified reporting to their clients. About 50 per cent of all public capital and up to 80 per cent of new money is now invested through platforms - largely because they are quite useful and do make life easier.

The problem is that they are also a cartel, in collusion with financial advisers, and although they do compete quite fiercely, they don't compete on price.

Platforms are basically the department stores of investing, allowing investment shoppers to choose a basket of funds before wheeling them to the checkout. Twenty years ago investors used to have to invest in a variety of individual funds and do their own paperwork; platforms simplify their portfolios and provide regular reporting.

But the main purpose of them for the investment industry is to facilitate the extraction of an average of 2 per cent in fees, which are then divided between the fund managers, the financial planners and the platform provider (usually a bank). And as with supermarkets, the platform providers have the market power.

There are about 100 investment platforms and master trusts in Australia, but the top 10 have about 85 per cent of the market. They are, in order, NAB/MLC, AMP, CBA/Colonial, ING/ANZ, BT/Westpac, St George/Asgard, Axa (Summit), Aviva (Navigator), Mercer, Macquarie Bank. The vast majority of financial advisers has a relationship with one of these groups and most of their clients' money, whether it's allocated pensions, superannuation, or just private wealth to be invested, goes on the platform. The adviser then helps the client choose several of the often hundreds of options available within the platform.

The platform operators choose which investment products to have in their store and, as with food manufacturers dealing with supermarkets, the key job of a fund manager is to get onto the platforms. If you are on a platform you are alive, if you are not, you're dead.

There are a few problems with the system.

The platform providers compete, but not on price. They compete by offering financial planners higher commissions - upfront and trailing - as an inducement to use their products.

Financial planners don't have to use them. No platform had Westpoint as one of its options, yet 120 planners were moved by very high upfront commissions to recommend it. (This is obviously a problem with financial planning, not the platforms.)

Platforms lock financial planners into commissions they often don't want to, or can't, receive. The Financial Planning Association now requires its members to verbally negotiate a separate fee for advice and not just rely on documented disclosure; these amounts may or may not coincide with the commissions embedded in the platforms.

And here is the biggest problem of all: none of the layers of "helpers" necessarily adds value.

This week Morningstar produced research which showed that over seven years the percentage of retail Australian equities-based fund managers who added value by using their investment skill was 4 per cent. That's right - 4 per cent. Forty-one per cent produced excess returns over the benchmark indices, but Morningstar concluded most of that was due to luck (because it wasn't consistent).

The platforms are convenient, but should they cost 1 per cent of your funds? Of course not. It is a retail cartel that deserves the attention of the Australian Competition and Consumer Commission.

Simon Hoyle takes a more adviser-friendly side of the perspective and give us an alpha and beta look at things:

AUSTRALIAN share fund managers are a reasonably competent bunch. They tend to produce returns that beat the market indices against which they're measured.

That's great when share prices are rising. Managers ride the market as it rises, and add a little bit of excess return. For most share fund investors that's how it's been for the better part of three years.

But a rising market can't go on forever. As investors contemplate life after a bull market, their thoughts are turning to something that investment professionals like to call "alpha". Michael Karagianis, executive director and head of asset allocation in Australia for UBS Global Asset Management, says investment jargon makes alpha seem more complicated than it really is. "Alpha is simply the excess return you can add as an active investor versus what you would achieve simply by investing in the broad market," Karagianis says.

The return that the market provides is called "beta", and alpha is the return that a fund manager achieves through its stock selection ability. A manager's total return is the alpha plus the beta.

"Alpha and beta have been joined together and both have been positive. Moving forwards, one of the things we are pointing to is that the Australian equity market is probably looking expensive at this stage. So the market performance could be quite disappointing.

"So people are beginning to zone in on alpha … as a discrete, stand-alone opportunity. People are now looking at alpha in isolation because they are not convinced they want the market risk."

However, an interesting phenomenon occurs when markets become flat, or turn down. A manager can achieve excess returns, or alpha, even though the market return, or beta, is low or negative. But it's cold comfort to be able to say your fund manager achieved significant excess returns when its overall return is negative.

The return from the market is usually the dominant portion of a fund manager's total return. If the market is up by, say, 8 or 9 per cent in a year, the excess return achieved by a fund manager may be no more than about 2 to 3 per cent.

[And you should ask yourself, why should any manager be paid anything at all based on the beta - the market's performance?]

If the market is down by, say, 8 per cent in a year, but a manager still achieves an excess return of 2 to 3 per cent, you'll still lose money - only you'll lose 6 to 7 per cent instead of 8 per cent. It's the compounding effect of these excess returns that fuels a fund manager's longer-term outperformance of a market or index.

Ron Liling, chief investment officer for Intech Investment Consultants, says an active fund manager's ability to generate alpha isn't necessarily linked to a market's beta, and nor is there a direct link between alpha and volatility. So if the market takes a dive, good fund managers will still be able to generate alpha, and changes in the market's volatility shouldn't necessarily affect a manager's ability to generate alpha, either.

However, a fund manager's ability to generate excess returns does depend very much on how it invests your money. The accompanying chart, produced by Intech, shows how different styles of investment can generate different levels of alpha.

On the far right-hand side is index fund management. An index manager simply replicates a given index and cannot - in fact does not seek to - outperform it. It simply does not try to generate alpha.

One step to the left is the enhanced index approach, in which a manager tries to outperform an index but does so by tweaking an index approach. The opportunity to generate alpha is minimal.

The "core" approach is the mainstream method of investing, where a manager makes active stock selection decisions to try to generate alpha, but can only invest "long" in a market. That is, it cannot do anything but physically own the stock it invests in or, alternatively, hold cash.

The "high-conviction" manager may also only invest long in stocks, but generally holds far fewer of them than a core manager does, perhaps only 20 to 25, or sometimes fewer. The manager aims to generate alpha through a high dependence on a small number of stocks that it expects to do better than the overall market.

The long/short manager can buy stocks it wants to own (if it expects them to rise in value) and "short-sell" stocks it does not like (a technique that allows it to make money if a share price falls). Alpha comes from being able to make money in both rising and falling markets.

Unlisted assets often generate significant alpha because they are uncorrelated to listed assets. That is, their returns don't mirror or follow returns from listed securities.

Hedge funds and absolute-return funds can use sophisticated investment techniques that allow the manager to generate alpha, because they can use strategies that are aimed solely at capturing alpha and can be effectively uncoupled from the market in which the alpha is actually generated.

Investors are reacting in a natural way to the prospect of lower market beta. They're not baling out of equity markets, but consultants are starting to talk to them about introducing different styles of management to portfolios, so that alpha generation continues but there's some protection against lower, or negative, beta.

Imagine if you could capture the manager's ability to outperform a market without being exposed to its risk. Better still, what if you could capture the alpha of a manager in one market, but the beta of another?

That's possible with some financial engineering. It's given rise to something known as "portable alpha" or "alpha transfer". By using futures and other derivative instruments, it's possible to eliminate the risk of one market and take on the risk of another, while capturing the alpha of a manager in what could be another market altogether.

"The ability to generate alpha isn't dependent on the market exposure you have," Karagianis says. "We can deliver just the alpha component by using futures to hedge out the market risk. It's called 'porting alpha' - moving alpha from a certain environment where you have a lot of market risk to another where there may be no market risk."

The key is determining which market you think a manager will be able to generate alpha in, which market's beta you're prepared to be exposed to, and how to transfer the alpha from one to another.

Liling says it's difficult to get a lot of alpha from bond markets - especially if you're restricted to high-quality, investment-grade securities. It's a lot easier to generate alpha in the Australian sharemarket.

On the other hand, the market risk in Australian shares is greater than in fixed interest. So what you might do, he says, is invest in an Australian share fund, and at the same time sell a share price index (SPI) futures contract. By doing this, you effectively take out any sharemarket downside risk. What you're left with is the alpha generated by the share fund manager. At the same time, you might buy a bond market futures contract, so you effectively buy the market return - the beta - of the bond market.

As Karagianis pointed out earlier, your total return is alpha plus beta. In Liling's example, it is the share fund manager's alpha plus the bond market's beta.

Liling says this is a complicated and potentially risky strategy because you can't always create a perfect hedge and, because there are costs involved, you don't always get all the alpha and beta you're chasing - but it gives an insight into how managers of absolute return and hedge funds think.

Eugene Liu, chief investment strategist for boutique fund manager Absolute Alpha, says any return can be thought of as nothing more than a "stream of risks and returns".

"I think that's the way you have to look at things," Liu says. "If you put them together, you get a total risk and return stream that's appropriate to an investor."

Liu says the equity market has been good to investors in recent years, probably returning an average of 15 per cent a year. But sharemarkets are volatile. In some years the returns are negative.

An alpha transfer could capture the alpha of an active Australian share manager, and the beta of a market less likely than the sharemarket to post a negative return.