Sticky fingers in many pies

The business of wealth management has been put under the microscope over the past month with the Royal Commission into the financial services industry. In March, the Commission focused on misdeeds in consumer lending and for the next two weeks in April it will be concerned with transgressions around financial advice.

The Royal Commission has highlighted the extent to which the major financials are involved in the business of managing Australia’s investments. Consequently, this week we are going to have a closer look at the funds management landscape in Australia. In particular we will examine the degree of vertical integration by the largest players of this industry that looks after A$3.4 trillion of investments for Australians.

Influence of the Major Institutions

The wealth management businesses of Australia’s major financial institutions (Commonwealth Bank, NAB, ANZ Bank, Westpac, Macquarie Bank and AMP) include funds management, life insurance and general insurance, investment administration platforms, and financial advice. The wealth management business is attractive for the banks, not only due to the government mandated growth that comes from rising compulsory superannuation contributions, but also because wealth management earnings carry a low capital charge. This appeal only increased with the $19 billion of capital raised in 2015 to meet Australian Prudential Regulation Authority’s (APRA) tougher stance on bank capital adequacy.

Whilst this might not be the most exciting of topics, changes to capital requirements have two important effects: they make funds management earnings more attractive to the banks, and also increase the cost of lending to business and home buyers. When a bank makes a standard home loan with a ~70% loan to value ratio (LVR), the Australian Prudential Regulation Authority (APRA) requires that the bank hold approximately $2 in capital for every $100 lent. This rises to $5 for every $100 in the case of a loan to a business that incurs a higher risk weighting. Mathematically, when a bank is required to quarantine more capital to conduct activities, their return on equity (ROE) declines. This decline may not seem very significant, but in an environment in which the Australian banks are facing higher capital requirements from regulators globally, earnings from wealth management are very attractive as they can boost the bank’s return on equity. Additionally, participating in the government mandated growing superannuation pool is seen as attractive to the major banks, since growing superannuation balances are expected to have a limited correlation with the credit cycle and demand for loans.

Vertical Integration: Clipping the Ticket at every stage

Over the last twenty years the major financial institutions either bought, or have organically created at great expense, a financial supermarket. This was based on the Allfinanz or bancassurance model, that assumed the banks could efficiently deliver banking, insurance and funds management through their existing networks, with employed tellers and financial advisors cross-selling “home brand” financial products. Aspirations to this model enticed the Commonwealth Bank to acquire Colonial in 2000, National Australia Bank to buy MLC, and Westpac to purchase BT and Rothschild Wealth Management. Additionally, by buying downstream financial advice groups, the major financial institutions acquired a distribution network for the financial products they manufacture such as managed funds, loans and life insurance.

In essence, the wealth management industry comprises a value chain of advice (financial advisers), portfolio administration (platforms) and manufacturing (funds management). The major financial institutions have captured a dominant market share in all three links in the wealth management chain via acquisitions and IT expenditure. As shown in the below chart on the right, the four major banks plus AMP and IOOF have financial relationships with just under 50% of the financial planners in Australia. Their market share had been increasing with acquisitions (such as Count, acquired by CBA in 2011 for example) and heightened compliance requirements that tend to favour the large institutions over smaller practices. However, over the past two years we have seen a swing away from this trend with the number of independent financial advisers growing. One of the potential outcomes from the current Royal Commission is that investors will become increasingly aware of the conflicts of interest inherent in the vertical integration of wealth management, and management and will shift towards using independent financial advisers.

The major financial institutions have also been very successful in capturing a large share in the business of actually managing the money. The above chart on the left demonstrates the dominance that the large institutions enjoy in “manufacturing” the investment products, or funds for sale to retail investors. Currently the major banks plus AMP manage almost 80% of the retail funds under management, though this may change shortly with CBA looking at listing its funds management arm Colonial First State via an IPO. Westpac’s share of funds management is declining as the bank continues to reduce its ownership position in BT Investment Management.
Finally, investment platforms are the “middle man” in the process, connecting the fund manager to the adviser by providing administration services and tax reporting for a client’s portfolio of managed funds, shares and cash. Platforms generally charge around 0.3-0.6% of funds under management annually. Whilst running platforms might not sound like a very glamorous business, it has been a lucrative area for the major financial institutions, which by virtue of their IT expenditure have been able to capture over 85% of this market. However, like financial advice, the dominance that the major financial institutions have enjoyed on the platforms is being eroded by smaller more nimble platforms such as Hub24 (1. see below note), Netwealth and OneVue. These platforms have been very successful in capturing market share from the big banks due to a combination of accessibility and the flow of financial advisers leaving the major financial institutions.

Not all good news

At first glance, vertical integration sounds like a solid way for banks to supplement banking profits in an environment of relatively anemic credit growth, rising capital requirements and government mandated superannuation flows. However, the events of the past few weeks demonstrate that the ownership of wealth management businesses by the banks do pose some risks.

Aside from the volatility in investment returns, wealth management businesses have delivered adverse headlines that could impact on an institution’s core banking business. Over the past few weeks we have seen financial services CEOs face the Royal Commission due to allegedly fraudulent behaviour and bad financial advice from the banks financial planners. Indeed, we have also seen the Treasurer flag the possibility of gaol time for bankers!

In 2017 Commonwealth Bank spent $437 million in advertising to build its banking brand. While AMP does not disclose in its annual accounts what it spends annually on marketing, we would be surprised if it was less than $100 million. One would have to imagine that a portion of the goodwill that this spend generates has been dissipated by headlines detailing malfeasance in these institutions’ financial planning, platforms and insurance divisions. The management teams at the major financial institutions must be concerned that unethical behaviour observed in the wealth management businesses should not spill over to damage their core banking brands that generate the bulk of their profits.

1. Disclosure: in April Atlas in partnership with Maxim Private have launched the Maxim Atlas Core Australian Equity Portfolio on the Hub24 platform.

Our Take

The major financial players have not built these vertically integrated wealth platforms (comprising advice, investment accounting and funds management) to see large amounts of value being “leaked’’ to service providers outside the network. This naturally creates strong incentives to recommend the house products over independent providers, or to favour house products over external products with similar or even slightly superior characteristics. As an investor in the major banks, we would prefer that they keep as much of the value in-house to boost payments to shareholders, however as an independent boutique investment firm, we also have a strong personal incentive to see the vertical integration model break down and for clients to seek out independent financial advisors.

Whatever the composition of the market, of utmost importance is that all financial service providers adhere to rigorous codes of ethical conduct, such as that of the CFA Institute as the unethical behaviour revealed by the Royal Commission damages public trust in the financial industry as a whole.



Sydney Morning Herald: AMP in strife following Royal Commission admissions

AMP in strife following Royal Commission admissions

AMP’s disastrous foray in front of the banking Royal Commission – including admissions it had misled customers and the regulator – is likely to have lasting effects for the battling wealth manager. AMP conceded it had made false statement to the Australian Securities and Investments Commission and senior staff ignored legal advice that charging of customers for services they did not receive was unlawful.


Short selling harder than you think!

Over the past week short selling has been a hot topic in the financial press after a noted US-based short seller released a very negative piece about listed fund manager Blue Sky Alternative Investments (BLA). This caused BLA’s share price to fall 50%, wiping $440 million from Blue Sky’s market cap. Short sellers are frequently derided as vultures, rumour mongers or un-Australian. However, in practice, shorting stocks is a difficult, stressful and lonely way to make money in the market, which is predominately skewed towards good news and wearers of rose-tinted glasses.

In this week’s piece we are not going to look at the merits of Blue Sky as an investment, but rather at the mechanics and issues around short selling equities. We see that much of the coverage on short selling over the past ten days reveals that many of those who hold strident opinions on short selling have only a limited understanding of how it actually works in practice.

Step one:  find a company with bad characteristics and a catalyst

In traditional long only investing the goal is to own good quality companies with honest management teams, clean balance sheets and solid future prospects. By contrast, when selecting a stock to short sell the desirable characteristics include companies with low or negative growth, high and increasing debt levels, a weak business model, over-valuation by a market, and possessing a shaky management team. However, a critical factor is the requirement for a catalyst; over-valuation or high debt in itself is rarely enough. In Blue Sky’s case it was the negative report from Glaucus. As very few investors have the luxury of lobbing a damming report from the sidelines and outside the regulation of ASIC and the ASX, we would look for events such as a potentially bad acquisition (preferably off-shore), heavy directors selling, or corporate turnover at management level.

Step two: Find the stock to borrow

Short sellers will then borrow stock from a stockbroker and sell it. They are essentially betting that the price of the target company will decline before they have to replace the borrowed shares by buying the stock back. This is often the step that is ignored in the financial press when talking about shorting a company’s stock, as it is wrongly assumed that investors can borrow stock to reflect their negative view on a company.

When borrowing shares to short sell an investor has to look closely at both the rate per annum that they are required to pay to borrow the stock, and where the owner is located geographically. The rate reflects supply and demand, and for most stocks is currently 0.5% per annum. For stocks where the shorting demand may be higher than the supply (such as Fortescue) the rate may be 15% or higher. In the case of small capitalisation or tightly held companies such as Blackmores, the short seller may be unable to borrow stock and thus cannot short sell.

In the case of Blue Sky, when we looked a week ago there was no stock available to be borrowed and the current short-sold position only represents 3 million shares, or 3.8% of the register. In a small and tightly held company such as Blue Sky most holders would not lend out their stock for short selling as to do so they would be providing short sellers with the ammunition to bet against their long position.  For example, BigUN – which is currently suspended on the ASX in February due to accounting irregularities – only had 500k of their outstanding shares lent out to short sellers, which is a mere 0.3% of the register. In the lead up to BigUN’s suspension as its share price was falling, the demand to short this stock would have been intense, but there would have been no stock available to be borrowed.

Step three: Dividends and Corporate Actions

The short seller is required both to return the shares to the owner when requested, and also to pass on any dividends paid. We also strongly prefer to borrow stock from foreign owners such as large index funds like Vanguard or State Street, as if you borrow stock from a domestic owner and a dividend is paid, short sellers are required to compensate the original owner for both the dividend and any associated franking credits.

What happens if the stock goes up?

If the short stock rises sharply, the lender will be required to give their broker additional collateral, or the broker will require the short seller to close out the short sale transaction before the planned timeframe.  A series of urgent requests to wire cash to your margin account to cover a short-sold stock that is rising sharply will test the mettle of even the most hardened short seller. In contrast, a long only position in a falling company can mentally be filed in one’s bottom drawer until it eventually comes good (or goes into administration).

This gives rise to the skewed payoff ratio from short selling, where the maximum gain is known (the stock falls to zero), but the maximum loss is theoretically infinite.

The Market can remain wrong longer than you can remain solvent

It would be wrong to view that short selling risky stocks is a smooth path to outperformance. Keynes, the father of modern macroeconomics, once famously said that “markets can remain irrational a lot longer than you and I can remain solvent’’. This quote particularly resonated with me after an unprofitable short selling of Fortescue prior to the GFC due to concerns about the over-valuation and debt situation of the company.

This trade was put on at $50 per share late 2007 and then was closed out at $70 four months later as the price continued to rise with no signs of slowing momentum. It was very painful to lose 29% in a short stretch of time; however, Fortescue peaked at $120 in June 2008 before falling back to $20 in December 2008. Whilst our investment thesis was ultimately correct, we were unable to handle the pain of a steeply rising stock and the associated unrealised losses and increasing margin calls.

Short squeeze

A “short squeeze” occurs when a heavily shorted stock rises sharply, forcing sellers to close out their position by buying back stock, thus causing further upward price momentum. Often when the market appears to overreact to a small piece of positive news, this is a short squeeze and it is similar to too many people trying to fit through a door.

For example, if JB-Hi Fi (currently 17% of the register have been “borrowed” by short-sellers anticipating that the price will go down) or Domino’s Pizza (18% of short) were to receive a takeover bid, the price would escalate sharply as short sellers look to cover their positions. A nightmare scenario would be a contested bidding war if you are short. In December 2017 we saw a short squeeze in Westfield when a bid from Unibail-Rodamco came through. However, unlike Dominos or JB Hi-Fi, the percentage of the property trust’s outstanding shares that we sold short was not a large amount, though we did see a spike in the share price that reflected the short sellers buying back stock to exit their positions.

Our Take

While short selling is often criticised and retains a negative connotation in a securities industry that is inherently biased towards optimism, we see that it serves a valid role in financial markets. Short sellers provide an alternative view and can aid both liquidity and price discovery in stock markets. In coming years – with MiFID II (new European regulations on stockbrokers) reducing the incentives for the investment banks to put out negative research and the decreasing value placed on sell side research – shorting will provide an alternative view. 80% of calls are buy or hold!

Investors should not look at situations like Blue Sky, BigUn or Slater and Gordon and view that it is an easy way to make money, nor that it is unfairly ganging up on a company. Even very experienced and adept short sellers such as Glaucus have made mistakes. For example, its shorts on Japanese trading house Itochu would have cost the fund manager substantially, with the price up +43% since they released their report in mid 2016.

Neither the Atlas High Income Property Fund nor the Maxim Atlas Core Australian Equity Portfolio currently employ shorting as an investment strategy. However, the author has previously managed a long short fund and has some understanding on short-selling as an investment strategy.

Monthly Newsletter March 2018

  • In March the listed property sector was effectively unchanged, a solid outcome in a month when the ASX200 declined by -3.8% and equity markets globally fell between -2% and -4% on concerns about a potential Trump trade war and rising tariffs.
  • The Atlas Fund declined slightly by -0.24% in a month were Listed Property effectively sat on the sidelines and ignored market volatility.
  • We see that after the pull back in early 2018, the listed property market is offering investors some interesting opportunities with a range of trusts offering stable distribution yields between 6% and 7% and are trading at discounts to their net tangible assets. In this environment we would expect management teams to be looking at initiating on-market share buy-backs.

Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2018.