Sherilee Bridge
South Africa’s R11-billion wrap funds industry is on the brink of collapse. The introduction of capital gains tax later this year threatens a large portion of the industry, much as it wiped it out in the United Kingdom. That’s not to say that there are those who would not be pleased to see the back of them. Wrap funds a selection of unit trusts wrapped together and managed as a single fund are still battling to prove their virtue in the shadow of their older sisters, unit trusts.
The rebellious child in the investment family came dangerously close to the end of its run when the government said unit trust investors, and not the funds themselves, would have to pay capital gains tax. As part of the clan, wrap funds would have had to pay their way every time a trade was made. Now, while being saved from extinction by the increase of the capital gains exemption from R1 000 to R10 000, wrap funds are still fighting to survive.
Wrap funds now account for a large portion of the assets in an underlying unit trust. Reports suggest that over the past year wrap funds have become the dominant buyers of unit trusts. Thus, when large-scale switching of trusts by wrap funds takes place, unit trust managers are forced to sell their best shares.
The wrap fund industry has been continually slammed for lack of regulation, absence of transparency, high costs and, most of all, for abusing unit trusts. Some linked-investment service providers have converted more than 50% of their unit trust book into wrap funds, willing to risk outflows if their in-house wrap manager underperforms. Wrap funds have been criticised for reshuffling the unit trust industry rather than expanding it. The greater part of unit trust trading volumes in recent times has been the result of churning by wrap fund managers chasing performance.
Momentum Advisory Services CEO Riaan van Dyk says the attack on wrap funds is unfair. He says about 50% of the assets of the wrap fund industry are in approved or licensed products to which capital gains tax does not apply. For the next three years at least the retirement industry will not be subject to capital gains tax and it will never apply to annuities.
“So if only half the industry is being affected, how can they say it’s dead? As with any new industry, people jump on the bandwagon but those who do the industry no justice will fall out again eventually,” says Van Dyk.
There are now 300 wrap funds, compared with 350 unit trusts. Fears that this proliferation of wrap funds will increasingly affect the performance of individual unit trusts for investors have been largely dispelled by fund management companies, but the long-term effect wrap funds will have on unit trusts and individual investors is still being digested. But it would seem that even the unit-trust industry is lagging behind international trends where there seems to be a greater move towards investors buying without financial advice. In the United States direct investment accounts for more than 50% of investments. Back home it is less than 25%. The Association of Unit Trusts insists that eventually wrap funds have to measure up to unit trusts in terms of performance, transparency and cost.
“Scared for their lives, most wrap fund managers have run for the strictly regulated shelter of their greatest critics by converting to unit-trust fund of funds.
“Some wrap managers are coming up with intriguing arguments for new products to side-step capital gains tax [and avoid appearing in the forthcoming wrap fund performance tables].” Some of the wrap fund disguises are fund-of-funds unit trusts, multi-manager unit trusts, structured funds and even managed portfolios. Momentum calls theirs “growth portfolios”. Funds of funds unit trusts are, in effect, identical to wrap funds except that they are governed by the Unit Trust Control Act.
Again much now depends on the final form of capital gains tax. Van Dyk says the panic over the future of the wrap fund industry sprung from the UK markets where wraps were squashed by the introduction of capital gains tax. There, he says, a wrap fund or managed unit trust portfolio is not competitive because every time there is a switch between unit trusts it is treated as a realised capital gain and is subjected to capital gains tax. Funds of funds, though, are exempt from capital gains tax, which is paid by investors when they sell their units.
But at least as funds of funds rather than wraps, these funds will be subject to regular performance reporting and that earns points in the Association of Unit Trust’s little book of bad investment products. Van Dyk, who has loosely formed an association to clean up the industry’s image, is an advocate of a more controlled industry. The unit trust industry wants wraps brought back under its association’s control to halt the rampant empire-building it allowed when it was too bothered, and too large, to deal with the little guy any more. But there is still scepticism about whether these wraps add value. In the long run it may be cheaper to invest in lower-cost options such as index funds, or even equity and balanced funds.
But for those who are into flavour-of-the-month investing, it will be difficult to beat the thrill of wraps and wraps should still outperform straight unit trusts. Then again, wrap funds, admits Van Dyk, have underperformed in the past year as did most fund managers.