If there are two types of fund that sound deeply unappealing in the world of finance, it is ‘zombie’ and ‘orphan’.
While there are differences between the two, investors caught in a zombie or orphan fund may find they are no longer treated to the same service or performance initially promised by providers.
Orphan funds, as defined by investment research firm Morningstar, are those with less than €100m in assets and with a five-year track record that has seen net inflows/outflows of €10m or less in each of the five calendar years to the end of 2017.
Morningstar research criticises orphan funds for languishing with little assets, neglected by asset managers’ marketing teams and saddled with high fees that deliver poor investor outcomes.
Zombie funds, meanwhile, are typically products offered by life insurers – such as pensions or with profits funds – that have closed to new money rather than transferring the existing assets to a new, open arrangement.
Vast exposure The extent to which investors are exposed to these kinds of funds is vast. Morningstar research shows £3.6bn of UK investors’ money is sitting in orphan funds, while the FCA estimates ten million policies are held by closed book pension providers, amounting to £400bn in assets.
The reasons a fund finds itself orphaned are numerous and varied. The Morningstar research cites a “tax impact or lack of paperwork from deceased relatives” as potential reasons. But ultimately, according to Laura Suter, personal finance analyst at wealth platform AJ Bell, fund managers are swamping the market with funds.
Laura says, “There are too many funds in the market and the majority of the fund flows go to a small percentage of those, so it is inevitable you will get subpar or orphan funds that limp on.”
Orphan funds also arise when investment strategies fall out of favour or the fee structure has become unattractive. The Morningstar research finds that, in some cases, negative-rated orphaned funds carry fees well above 2% and the average charge for an orphan fund is 1.29%, which compares with 0.67% for an average equity fund.
Many zombie funds also have a problem with fees. PensionBee’s Robin Hood Index 2018 shows that Phoenix Life, which is a closed book pension specialist, has one of the highest annual charges of 1% and is the worst offender for exit fees.
Philip Milton CFP™ Chartered MCSI, managing director at Philip J Milton & Co, says exit fees can pose a significant challenge for investors trying to escape the clutches of the zombie funds. “Exit penalties can see people stymied from doing anything because they will see their money eaten away in charges. The FCA cap has helped, but it has always been a problem,” Philip adds.
A question of costIf investors are paying high fees for poor performance and limited attention, why are providers not taking greater steps to protect their clients?
The most obvious defence would be to close orphan funds and merge these with similar, more successful offerings. Merging funds can make a real difference to the performance of orphan funds since they might be reinvigorated under a new manager as well as benefiting from economies of scale.
However, for smaller investment houses, there may be no suitable alternative into which investors can be switched. It can also be expensive and complicated to close a fund, which means there is little in the fund manager’s interest to take such action.
The FCA is critical about the way in which fund managers merged funds in the past. In its Asset management market study from 2017, the regulator says that the cost of mergers or closing a fund “is often borne by the fund rather than the fund manager”. However, the regulator does not offer fund managers any assistance in closing funds and does not have plans to make it easier for providers.
With no obvious incentives or strategies for providers to merge or close orphan funds, the onus is on advisers to help ensure their clients have a clear line of sight on the investment manager. They should ask questions of the investment manager’s long-term commitment to the fund.
Laith Khalaf, senior analyst at Hargreaves Lansdown, recommends clients review their portfolios regularly to ensure none of their funds have become orphaned. If it appears this is the case, the adviser should have a strategy in place for helping the client.
Fighting zombies The opportunities to merge zombie funds are slimmer. The chances of finding enough similarity between different products – especially if they have been brought out by a new firm – are few and far between, and the complexities involved may be prohibitively high.
Philip says an alternative is for investors to move out of zombie funds and onto a fund platform. “Bringing all investments onto a platform that is accessible and transparent can be meaningful for clients, particularly if they have several investments spread about,” he explains.
Investor responsibility Reputational issues and market forces should drive providers to tackle their orphan and zombie funds, but investors have a responsibility to ensure they undertake suitable due diligence.
Laith says the relevant information is available in fact sheets but accepts investors may not know what to look for.
“Fact sheets aren’t the easiest read. If you don’t take some time to understand your investments though, the chances of staying invested in orphan funds longer than you might wish are higher,” he says. For example, investors must be clear on charging structures, including whether they bought the product at a time when commission fees were included in the costs.
Even with careful due diligence, however, investors can still find themselves caught. Investment strategies fall in and out of favour and regulators change, as do charging structures. The likelihood of new orphan and zombie funds appearing frequently is high, but what matters more is how advisers can help their clients escape.
The full article appears in the July 2019 print edition of The Review. All members, excluding student members, are eligible to receive the quarterly print edition of the magazine. Members can opt in to receive the print edition by logging in to MyCISI, clicking on My account, then clicking the Communications tab and selecting ‘Yes’.
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