Asset management funds continue to grow at a rapid pace, especially in Spain, where they are about to reach historically high levels. Several factors are responsible for their revival: The recovery of financial markets from the low points of March 2003; the appearance of new approaches that protects investments against possible declines in the stock market; and a more favorable tax environment. Nothing has been able to halt their advance – not even current geopolitical uncertainties, stock market volatility, or several scandals involving fund managers.
The investment fund industry has shown unexpected strength, recovering from the hard blow it sustained at the end of the 1990s, when the technology bubble burst and the stock market plunged into crisis. Investors watched their savings drop in value, even though the funds were managed by professionals. Many investors stopped placing their trust in funds.
Despite that merciless collapse, the sector has since recovered with greater energy. In Spain, fund assets are now at within one billion euros of their historic high point of May 1999, when they reached 213 billion euros. In the United States, the numbers tell the tale: Investment funds closed out last year with net inflows of $291 billion. This was the highest figure in seven years and 71% higher than in 2002. By the end of the year, fund assets in the United States rose to $7.9 trillion.
All that was taking place at the same time as several scandals came to light involving irregularities on the part of more than 20 major U.S. fund managers. In most cases, the managers were favoring large-scale investors who had a short-term horizon to the detriment of smaller investors who had a medium- or long-term horizon.
A Boost for the Markets
How can you explain the reaction of investors? Roberto Hernán, professor at the EuropeanUniversity of Madrid, believes the condition of financial markets has been the decisive factor. “An investor always has to decide to invest in something. Interest rates are at such low levels; in the U.S. at 1% and in Europe at 2% – in both cases, the lowest levels in the last half-century. Cash and fixed income are no longer a good option, which leaves only the stock market. But in hard times, you don’t trust yourself, so you put your money in the hands of professionals.”
Eduardo Badillo, a UniversityofNavarre professor who specializes in investment funds, sees several keys for their growing acceptance among private investors. “The big advantage of funds is that they can be adapted to the needs of each person. There is tremendous diversity, and it is growing daily. If you are a fearless investor, you can choose a fund that has no variable income and invest 100% in stocks. But if you have a less risky approach, you can choose a fund that is 50% in stocks and has the rest in bonds. The supply [of funds] is enormous.”
According to Badillo, these products “allow people to make investments that one person could not carry out as an individual. For example, in order to invest in fixed income [instruments], a private investor would need a very large amount of money, but this is feasible for an investment fund.” He adds, “Another advantage is that you can get into other markets that are [otherwise] hard for private investors to get into. For example, if an investor wants to invest in Germany or in an Asian market, it is much easier to use a fund.” Summing up, Badillo notes, “The nest egg, acting through an investment fund, is going to move around in response to variables that a private investor could not access all by himself.”
According to Hernán, “Funds are a very attractive product because they bring the market much closer to the small investor. If you want to invest 10 million euros in stocks, you would have to buy lots of shares and pay a lot of commissions in order to diversify. But you can diversify, using a fund.”
The popularity of such products also reflects a growing emphasis on these products by large financial-services companies. The commissions they earn on these products allow the firms to improve their bottom line at a time when low interest rates make it hard for banks to profit in their traditional lines of business. Banks depend on maximizing the difference between the interest they earn from loans and the interest they pay to their depositors.
Better Tax Treatment in Spain
Beyond general considerations, there is a special key to the Spanish market. “In Spain, the rise of investment funds comes largely from the tax reform that went into effect on January 1, 2003. The appealing thing for investors is that they can change funds without paying any capital gains tax. This reform has given a major boost to the market,” Hernán emphasizes.
The numbers prove the positive impact of tax reform. Last year, 25% of all fund investments – one out of every four euros invested in funds in Spain – involved a transfer from another investment fund. The figures are growing even faster this year, according to Inverco,Spain’s association of investment institutions and pension funds.
Beyond the real impact on money flows, tax reform has led to enormous changes in the supply of products – on the part of financial service firms – and the ways companies sell those products. There have also been significant changes in the way fund managers relate to their customers and competitors. Sergio Torassa, a former professor at PompeuFabraUniversity, says, “The change in tax law has gone very well. If you decide to reinvest your capital gains, it’s very important that there are no tax consequences.”
According to Torassa, now an independent consultant, several major trends have emerged from the tax reform. “On the one hand, there is more competition. You go out on the street, and you see large-scale ad campaigns for companies that want to attract your savings. They use posters, promotional gifts, and so forth. The investor can follow the profitability of his or her investments, little by little. Now the companies have to make clear moves to attract new customers – or watch the competition steal them away.”
“On the other hand, [the tax reform] has led to an improvement in the products that firms offer. The line-up is now more sophisticated, as in the case of ‘guaranteed’ products of the second generation, or ‘dynamic monetary’ products, or ‘controlled risk’ products. Finally, [financial service firms] have to develop much broader sales strategies. They not only have to attract customers; they must develop strategies for retaining their customers. Institutions must carry out strategies that have a greater reach. Until now, they only said, ‘Bring me the money.’ Now, they have to show each customer that they care.”
For Torassa, these trends have a liberating impact on investors. “Before, when you trusted your money to a manager, you were a captive; you trusted the manager to do a good job. Now, when they take away the wall, the manager has to use his imagination to create products that retain you as a customer. If the product they offer you turns out to be bad, you can get rid of the manager.”
Torassa believes these changes “have led to a very significant concentration in the [financial-services] sector, because it is the large firms that have what it takes to launch the large-scale sales and marketing campaigns [for these products].” The ten largest Spanish funds, which manage a combined 75% of all assets [in Spain], took in 91.7% of all new money invested in funds last year.
The Success of Guaranteed Funds
A paradoxical result of the greater mobility of savings is that the most popular products during the past year were the “guaranteed funds” launched by Spain’s largest firms. Although they sold well, these funds have been criticized in Spain’s business schools. “It means that the fund has to provide additional profitability beyond simply providing an asset that is risk-free, which is public-sector debt. However, many of the guaranteed funds that came out at the beginning of 2003 have not achieved that [level of] profitability,” notes Badillo.
The first generation of ‘guaranteed’ funds guaranteed 100% of each investor’s initial investment – although in some cases, the guarantee involved a somewhat lower figure. Moreover, these products promised investors that they might profit from a possible rise in the stock market. In effect, these funds served as a panacea for the financial sector – a product that protected investors against losses if markets fell but provided a significant return on their capital if markets went up.
“The advertising departments of financial-service firms hit the nail on the head with their campaigns for guaranteed funds, because they took aim at something that truly worried investors after three years of falling markets,” says Torassa. “First, to guarantee the principal. Then, to be able to participate in a possible recovery of the market.” “The major financial services firms pulled off a successful marketing campaign for these products,” adds Hernán. “They sold them as an opportunity to make a lot of money without taking any risk.”
This much is clear: The sales campaigns were removed from reality, because the high rates of return they promised could not be achieved, given the way these products were structured. A guaranteed fund invests most of its capital in bonds, in order to guarantee 100% of the capital. The rest of the capital is used to purchase derivatives, with the hope it can make additional returns on that money. However, interest rates were very low, and the price of derivatives shot up because of the high volatility of markets. As a result, it wound up being very hard to make a significant profit.
For all that, ‘guaranteed funds’ were a big hit [in Spain] last year, attracting 10.887 billion euros, because of the sales strategies of the major financial-service firms. Moreover, all this took place despite the fact the products carried high commission rates that contradicted the spirit of Spain’s new tax regulations.
Hernán believes the high commissions were necessary because of the special way these products are structured. “It makes sense to have high commission rates because, to guarantee the capital of the participant [investor], the bank assumes the risk in his or her portfolio. If the investor decides to withdraw his or her money before the end of the guaranteed period, the bank must restructure its investments, and this involves a cost.”
Torassa sees other reasons for high commissions. “In the beginning, some institutions chose this formula in order to retain the savings of participants by imposing higher commission rates.” More recently, firms have made changes to their product line-up, launching another type of guaranteed product that has less restrictive conditions. According to Torassa, the first generation of guaranteed funds “was bread for today, and hunger for tomorrow. Guaranteeing people their savings for the medium term has an effect that only lasts about a year, if it turns out that your product is bad,” he argues.
The View Regarding the Scandals
Recent scandals in this sector turned out to have relatively little impact thanks to quick action on the part of regulators. Most important, the Securities and Exchange Commission (SEC) toughened [relevant U.S.] law to prevent additional cases.
Torassa believes that investors’ confidence in funds is more than justified. “The dean of HarvardUniversity used a metaphor that applies to this case. We have some rotten apples in a basket. Are the apples rotten or is the basket rotten? I believe the problem is the apples, and you have to get rid of them.”
Similar cases could emerge in Europe, according to Torassa. “Authorities say that regulation in Europe is much stricter. But they also said that when we had the Enron scandal, and then we had the Adecco and Parmalat scandals in Europe. It is normal to have some rotten apples, because some managers are too ambitious, just as some people are in any activity. The challenge is that the basket – the system – must be clean enough to detect those people and get rid of them.”
According to the Financial Times, the first scandals involving European funds are now emerging in the Netherlands. Authorities in that country are investigating alleged infractions in the operation of one of the largest institutions in that country. In Spain, a computer error, calculating the asset value of the funds of Afina Pentor, a subsidiary of Commerzbank, raised suspicions. However, it was determined to be a case of human error, not an act of fraud.
If there aren’t too many rotten apples, and the rotten apples are quickly separated from the rest, the investment fund industry should have an attractive future, experts agree. Torassa says, “Right now, the supply of products is very tempting, including ‘dynamic monetary’ products, ‘second-generation guaranteed’ funds, and products of ‘controlled-risk management.’” These products allow investors to set a maximum level of loss with a very high level of confidence. This style of management is called “Value at Risk” or “VaR.”
In Torassa’s view, “Investors can choose from a very attractive menu. The best approach is to take a small bite out of everything; to diversify first, and then invest [more] in those areas where you get the best results. That is the best advice I can give investors.”
Hedge funds are among the most popular dishes on this menu. This kind of product looks for positive returns on investments, independent of ups-and-downs in the markets. These funds invest through derivative assets, and with a non-traditional style. In recent years, hedge funds have enjoyed an enormous boom. At the end of 1998, $350 million in assets were under hedge-fund management. By the end of 2003, the figure more than doubled to $750 million.
In Spain, however, hedge funds cannot yet be sold on a massive scale. The CNMV, which regulates securities markets in Spain, is still looking for a way to permit the sale of hedge funds while maintaining sufficient protection for investors. The major snag is that managers of these funds do not reveal their style of management nor their [specific] investments. As a result, these funds lack transparency.
Hernán says that the CNMV, like other agencies worldwide, must set a high regulatory standard. “This is a very dangerous product, and regulators must control it. It can be very attractive for professional investors, but it is not for individual investors because it is very risky.”