Emergence of new product and fund types always provokes discussion about the understanding and suitability of products for consumers, as IFAs have to assess whether this year's big thing will in three years time face mis-selling claims.
Distribution funds – a wolf in sheep’s clothing?
One of the very many joys of children is their ability to see things for what they are. I asked my daughter did my hair look like the lady from 101 Dalmatians (Cruella DeVil) as her hair also had black and white in it?
As calmly as ever, my four year old announced that my hair didn’t look like Cruella’s and mine was solely grey.
- "Are you sure sweetheart? Have a look again."
"Nope Dad, just grey." The truth hurts.
We read a story the other day about the big bad wolf.
- "She's not a real grandma is she, dad?"
But her response did set me thinking about finance. Unfortunately, what happens when consumers choose to invest their money is we don’t always notice the big teeth and hairy faces sticking out of pyjamas when we expect nice, safe, cuddly grandma.
Distribution funds are flavour of the month at the moment and there are many companies looking to get in on the act. For many companies, the story looks good, but then so did the Titanic - it was great on paper but not so handy on water. So what’s the problem with some certain funds?
Distribution funds are designed to be medium to low risk vehicles. Their general makeup is:
- to invest in equities for growth and a little income, while the fixed interest element provides both income and capital stability;
- a reasonably well-targeted (income) yield from the investment and,
- charges as low as possible with such funds, because there aren't that many good fixed interest opportunities around and the impact of excessive charging is a big differentiator.
Looking at certain funds, however, it’s not long before the big teeth are obvious.
- "What a lot of junk bonds you have. All the better to give you a high yield my dear," cackled Grandma.
Some firms are attempting to expand the investment potential of the corporate bonds market by suggesting the yield on bonds are now so low, a wider range of investment options are required, to prevent bond yields from falling further.
The reality is, however, these fund brochures fail to show investors just how narrow bond spreads were in the summer of 1998, when Russia defaulted on its debts repayments and there was a global flight to quality.
Moreover, fund managers are arguing for the inclusion of non-investment grade corporate bonds with their funds – vehicles on which the risk of default and capital loss is considerable. The very reason companies issue junk bonds is because they are unable to borrow at the usual rates. Lenders charge them a lot more to help cover the risks of the loan going sour.
Charges on these products are also taken from capital which means while the investor happily continues to take income from the investment, anything from between 1.2% and 1.75% is being gnawed away from your capital every year, let alone the impact of defaults on the junk bonds.
Despite what might seem to be a rather negative view of distribution funds, there are some good investment options around whose fund manager have several years of experience.
Not all funds are as bad as I’ve painted because the differences between most distribution funds is very little and there is nothing wrong with adding a little risk. We live with it every day in everything we do. But it is just important to know what risk investors are taking. After all, grandmothers shouldn’t have sharp teeth and hairy noses.IFAonline
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