Not as simple as ABC

What’s in a name? Certainly the name of a fund can be very misleading and there have been some corkers over the years.

You only have to go back a couple of years to find a perfect example. Investors would have been justified in thinking that the Standard Life Sterling fund was invested in cash and that it would not lose money. But the fund did fall in value because it invested in toxic debt as well as cash. Standard Life was not the only fund manager to have a cash fund that lost money during the financial crisis. Cash funds offered by the Pru (ironically as it transpired named Cash Haven Trust) and Clerical Medical also lost money because they were exposed to mortgage debt.

In 2005, NPI was forced to compensate investors after it failed to mention that its property fund had not held any property investments for at least two years. Instead, the money had been held in cash.

The great and the good in the investment and pension industry have long been concerned that savers have been misled with the names of the popular managed sectors and have looked to give them a name change. You probably would have thought that giving a fund a name would be a relatively straightforward procedure. It appears that it is anything but.

You only have to take a look at the problems the Association of British Insurers and the Investment Management Association have had this year in renaming the managed sectors to see why.

It was only a month ago that the Investment Management Association (IMA) announced the findings of an industry-wide review into the categorisation of managed funds.

The IMA has wasted the opportunity to write meaningful sector definitions that can be properly understood by investors

Under its proposals, the three Managed sectors were to be renamed Managed A, Managed B and Managed C. A new sector, called Managed D, was also to have been created for managed funds with a lower risk/return profile than the current Cautious Managed definition – which allows funds to hold up to 60 per cent in equities. A consultation on the new names was started, with the aim of introducing the first three by July 1, and adding the fourth sector name by January 2012.

At the time Dick Saunders at the IMA admitted that it wasn’t as simple as A, B, C. He said: “One approach to naming (a sector) would be to get out the Thesaurus and look for different adjectives. But it quickly became clear that words like “defensive”, “flexible”, “aggressive”, “dynamic” and so on would run into exactly the same problems as the existing names. The Sectors Committee went through all this exhaustively. It was clear that none of the obvious solutions were satisfactory, and that it made sense to go for something that invited advisers and consumers to look behind the names. So the proposed names – Managed A, Managed B, Managed C and a new Managed D – were deliberately concise and neutral.”

He was also open to criticism and on his blog he wrote: “If you don’t like what is proposed, tell us what you would do instead.”

And the industry did just that. Gary Shaughnessy, UK managing director at Fidelity International responded: “To say we are disappointed in the outcome to this review is an understatement. The IMA has said that it is important that these sectors are properly understood by investors, but in our opinion the new sector differentiations are meaningless and actually increase the opacity for investors.”

Skandia was equally damning in its response. It said that renaming the managed sectors from Active, Balanced and Cautious to A, B and C was “quite frankly a farce”. “Everyone knows what A, B and C stand for so will simply continue to use the old names verbally,” says Graham Bentley, head of UK proposition at Skandia. “However, the whole exercise has missed the point which is that consumers are confused by individual fund names that imply a level of risk that does not match the real risk level of the fund.”

Bentley pointed to research by Skandia that shows that 81 per cent of financial advisers expected funds in cautious sector to have a risk rating of 4 or below out of 10, with 10 being highest risk. Yet analysis of the IMA cautious sector using Skandia’s Managed Fund Analyser shows that the vast majority of funds (71 per cent) have a score of 5 or more and some of them have the highest risk scores of 9 or 10. Any of these funds that are labelled cautious or defensive could be misleading to investors.

This research isn’t too surprising. Last year cautious managed funds were in the dock for being higher risk than their name suggests. The research upset the IMA.

According to the current rules laid down by the Investment Management Association, cautious managed funds are not allowed to have more than 60 per cent invested in equities, while they must have at least 30 per cent invested in fixed interest and cash.

Autoenrolment is a great opportunity to close the trust, knowledge and engagement gaps but we need to do a lot better than this

But Clarmond Advisors found that nine funds in the sector, that on occasions breached the rule of a “maximum equity exposure restricted to 60 per cent of the fund”. The equity content of “cautious managed” funds ranged from 73 per cent down to 0.5 per cent, with more than 81 per cent of funds having 30 per cent or more in equities, it said.

The IMA disputed the figures, while some fund managers said that they had given incorrect information to the fund analyst Clarmond used for their research. But during the sniping it emerged that these funds also invested in futures and swaps – investments that tend to be associated with risk (irrespective of what they try to do).

Perhaps the IMA should have followed the advice of the ABI which found that alphabets don’t work for consumers. It has already gone ahead with changing the names for its ABI managed sectors (introduced in April). Meawhile, the IMA has now issued a circular to member firms stating that the consultation on new names will be extended to July 29, with any implementation put back to October 1.

The ABI research showed that once respondents understood how mixed-asset sectors work, most came to see the current names as lacking in clarity and a source of potential misunderstanding.

For example, respondents consistently underestimated the maximum proportion of shares that can be held in Cautious Managed and Balanced Managed funds.

Helen White, the ABI’s acting director of life and savings, says: “It was becoming increasingly clear that terms like “cautious” were confusing for consumers so the ABI was keen to act quickly and make changes to help customers. Our research of more than 2,600 adults told us that the new names are significantly less likely to lead to consumers misinterpreting the type of funds they choose to invest in. “We found that consumers want simple information about the minimum and maximum amount of their money that an investment fund will put into shares. The new fund sector names do just that.”

It carried out some extensive consumer research before deciding on the names (see box below) and letters that failed to make the grade. It said that a few respondents noticed that B, C and D might correspond to Balanced, Cautious and Defensive. But most of all respondents simply found these names unhelpful, and since they denied that they would base any decision solely on the name, whatever it might be, they rejected the argument that these names alone would force them into further research.

The ABI research even showed that the word ’equity’ is baffling to many – many surveyed thought it was associated with home ownership rather than the stock market.

Shaughnessy adds: “The ABI changes were much nearer the mark and we had hoped the IMA would improve on this further. Instead, the IMA has wasted the opportunity to write meaningful sector definitions that can be properly understood by investors.”

To say we are disappointed in the outcome to this review is an understatement. The new sector differentiations are meaningless and actually increase the opacity for investors

But Fidelity is still not satisfied with the new ABI names. It fears that by stating the equity content it implies that this is the only risk element in the fund. It suggests that with derivatives now widely used and a number of other asset classes like property and commodities now commonplace in managed funds, that this could be misleading. “We believe that the amount the fund can invest in total in “risk assets” would be better. Detail on these assets (and indeed the statement that bonds and other defensive assets are not entirely without risk either) could be included in the definition/notes of the sector.”

Most savers in GSIPP and GPP will be default savers. Experts say that the default fund (post auto enrolment) must reflect member needs so is likely to be a mixed fund with a relatively low risk rating – cautious or defensive managed in the current descriptive language – in most workplaces.

“These enrolled employees are by their nature not particularly financially aware and the new IMA sector classifications of ABCD for mixed funds would do nothing to help members of these schemes understand what they are invested in. The ABI has a separate set of classifications based on the equity content of mixed funds which is not compatible with the IMA sector classifications,” says John Lawson at Standard Life. “Where I think that the IMA fell down is that it is not built with the customer in mind. Advisers (and online DIY sites) have a number of tools that aim to determine a customer’s attitude to risk usually in a range of five or seven steps such as low, low-medium, medium, medium-high and high.”

Lawson believes it would be useful if the IMA and ABI linked their sector classifications with the customer’s understanding of where they fit within the risk scale determined via the adviser or risk profiling tool. “The whole industry needs to get together to harmonise its approach to risk grading and sector benchmarks.

“Whilst I am open to what the finished article might look like, it is clear that the current approach is complex and confusing for customers, particularly the less financially literate. The industry, fund managers and insurers, needs to start putting the customer at the centre of what we do rather than talk in impenetrable technical terms. Auto-enrolment is a great opportunity to close the trust, knowledge and engagement gaps but we need to do a lot better than this.”

Some might argue that the fund name is immaterial if it doesn’t perform and there have been some notable under achievers from the big guns.

It is why Laith Khalaf from Hargreaves Lansdown, asserts that the new categories won’t really take us any further. “Category labels don’t tell you everything you need to know about your investment. You need to look under the bonnet of your fund to see what its parameters are and where it is investing. In fact this is true of all funds, not just the mixed asset funds that seem to be the cause of all this consternation.”