Finance: MUTUAL FUNDS
SMOOTH SAILING FOR OFFSHORE FUNDS
Why this $1 trillion market is likely to keep growing strong
Offshore. For decades, investors have identified the term with secretive tax havens, usually small islands, frequented by the ultraprivate and megarich.
Today, offshore has lost a lot of its cachet. But no one is fretting. As many of the world's stock markets boom, offshore mutual funds are proliferating. As a result, less well-heeled doctors, dentists, and other wealthy professionals living abroad now can reap the benefits of investing in areas levying little or no tax on investment income and offering safety from political and economic turmoil.
Offshore funds these days are also being run in other than such traditional locales as the Channel Islands. Europe's main offshore fund centers are cities, especially Luxembourg and Dublin, where fund assets have grown 50% since 1993. All told, Standard & Poor's figures mutual funds outside the U.S. are worth some $2.4 trillion (chart), double what they were in 1990. As much as half of that is held in offshore funds, which, unlike their domestic counterparts, are marketed across international boundaries.
The family of offshore funds is likely to continue growing in coming years. For one thing, as countries across the industrial and developing world try to cope with overburdened state pension systems, they are moving toward private retirement plans run along U.S. lines and based on mutual funds. Further, overseas investors from Hong Kong to Hamburg have caught the same mutual-fund bug that has swept the U.S., and there is no sign it is abating.
Offshore funds aren't marketed in the U.S. because their sponsors don't choose to register them with the Securities & Exchange Commission. In fact, a large number of fund sponsors refuse to take on U.S. residents out of fear of being obliged to submit to SEC scrutiny. But some Americans, with a taste for the unusually venturesome strategies offered by offshore managers, have found ways around these obstacles.
Investment advisers say one way is to set up brokerage accounts in Guernsey, the Cayman Islands, or other havens through special companies called nominees. For a fee, these nominees will buy and hold offshore fund shares for investors. And one German-owned investment house specializing in overseas securities, New York Broker Inc. of Fairfax, Va., will help clients track down offshore funds willing to accept American customers. The firm's president, Catherine Ayers-Rigsby says "we consider it part of our service" to persuade the funds to provide customers with tax reports acceptable to the Internal Revenue Service as well as hard-to-find performance updates and prospectuses.
For the most part, however, the real action in offshore funds remains, well, offshore, where a familiar band of global money managers, including Deutsche Bank, Robert Fleming, Fidelity Investments, and Chase Manhattan, are fighting it out. In fact, U.S. money managers rank among the most ardent players.
Fidelity, for example, recently began pitching no-load funds in Germany and Britain. Boston's John Hancock and Houston's AIM Funds, which is being acquired by Britain's Invesco PLC, are setting up shop in Luxembourg and Dublin, which has pushed to build money-management industries to help spur local employment. Safra Republic Investments (U.K.) Ltd., a London-based affiliate of Edmond Safra's Republic New York Corp., is rolling out a family of 21 offshore funds focusing on asset allocation strategies.
DECLINING FEES. U.S. firms have a long way to go before they can even come close to laying claim to the offshore industry, however. Lipper Analytical Services Inc. estimates they manage only 3.7% of the mutual-fund assets held abroad. But the allure of offshore business is still compelling for managers facing intensifying competition and declining fees in the increasingly crowded American market. Says Robert B. Milroy, a Vancouver-based financial consultant and author of The Micropal Guide to Offshore Investment Funds: "You're reaching saturation in the U.S. Money managers are expanding globally. The new horizon is Southeast Asia and Europe."
Some U.S. managers have stuck to selling offshore funds that are mainly clones of ones they run domestically. But other fund sponsors take a different tack. Because offshore funds don't need to heed SEC rules limiting the use of leverage, short-selling, and derivatives--a principal reason why they aren't sold in the U.S.--managers say they feel freer to pursue more aggressive approaches that pose higher risks than American fund investors--or the SEC--might be willing to stomach.
Take Victor Flores, manager of San Antonio-based United Services World Gold Fund. Marketed to U.S. clients, the domestic fund invests largely in well-established bullion producers and is up about 27% this year. But offshore, Flores runs the U.S. Precious Metals & Natural Resources Portfolio, a Guernsey-based fund that bets on little-known mining outfits and has run up a spectacular return of more than 240% in 1996. Flores owns such companies as Armada Gold Corp., a Canadian-listed producer run by an Australian geologist with a property in Siberia. More than 90% of Flores' offshore portfolio has gone into such high-risk investments, against 5% in his more staid U.S. fund.
George Soros' $5.4 billion Quantum Fund, which relies on leverage, derivatives, and big "macro" bets on countries, also has thrived amid the offshore market's investment freedom. So have many smaller competitors, including Leveraged Capital Holdings, a $600 million offshore fund managed by the Edmond de Rothschild Group International Funds from London but domiciled, for tax and regulatory purposes, in Curacao. Over the past 27 years, Leveraged Capital has posted a 15.3% annual total return--nearly five points better than the Standard & Poor's 500-stock index, by investing in hedge funds managed by others. Says manager Rick Sopher: "We have an incredibly broad mandate because we're not governed by the SEC or anybody else."
The success of so many offshore managers prompted BUSINESS WEEK's international editions on Nov. 11 to launch an exclusive Scoreboard on the world's 500 largest offshore equity funds. (The Scoreboard is currently available on BUSINESS WEEK Online at America Online.) Modeled on BW's long-running coverage of mutual funds in the U.S., the offshore Scoreboard measures returns, reveals portfolio holdings and expenses, and provides risk-adjusted ratings singling out funds that have produced the best gains with the least volatility over the last five years.
By BW's reckoning, the stars of the past 12 months have been funds investing in the postcommunist economies of Eastern Europe and Russia (page 150), where spreading reforms have buoyed investors' hopes. But not surprisingly, many of the best-rated funds over the longer run were those that have stuck close to the bull market on Wall Street.
Take Fleming Flagship Funds American and JF American Growth, two essentially identical big-cap funds sold in Europe and Asia, respectively. Managed by Jonathan Simon of Fleming Capital Management in New York, each tallied a tidy average annual return of 23% over the five years ended Sept. 30. Right now, Simon is buying shares of Kimco Realty Corp. for his funds, which invest mainly in U.S. stocks. A real estate investment trust that runs strip malls in the Midwest and Florida, Kimco sports a comfortable 5.8% yield.
Solid performance this year has helped conceal the fact that in general, offshore funds hit their investors with far higher fees and expenses than funds sold in the U.S. market. One manager for a U.S. life-insurance company says his profit margins on offshore funds are easily 20% greater than those he sells at home. Why? In the offshore market, competition is less intense and toll-free calling and direct mail are still in their infancy. So sponsors still can demand 5% loads, maintain high management fees, and pass on fees levied by banks for holding funds' assets in their custody.
SMALL PRINT. Peter Jeffreys, managing director of London's Fund Research Ltd., estimates that the average Luxembourg-based offshore fund has an overall expense ratio of 2%, nearly double the average for funds in the U.S. But that's only a rough guess. With no SEC to demand full disclosure, many sponsors report all their charges in the small print of annual reports, if at all. Another possible reason why the funds can get away with higher expenses: They don't file information on customers' income and capital gains with any tax authorities. Instead, they rely on the willingness of investors to comply with local tax laws. "You'll never see an offshore fund producing a tax return for an investor," concedes the head of a major bank's fund group. "The whole industry is based on trying to make sure investors who want to avoid taxes can do so." With many investors thus avoiding taxes, a few extra basis points in fees probably never even get noticed.
In addition to falling short of U.S. standards on disclosing fees and expenses, many offshore funds are also chary of making detailed quarterly releases of portfolio holdings and trading activities. Such reporting lets investors compare funds more easily and spot those that are performing better or worse than those with similar portfolios. Industry critics contend that this lack of timely reporting made it easier for rogue fund managers at Jardine Fleming Securities in Hong Kong and at Deutsche Morgan Grenfell, Deutsche Bank's London investment banking unit, to run huge irregularities in their accounts before being snared in scandals over the summer. Had the managers been obliged to report more fully and frequently, the critics contend, alarms might have gone off earlier.
Fortunately, such excesses have been rare. Indeed, managers at several fund groups say they are moving toward U.S. standards of openness as investors demand more information. As the offshore industry matures, it may start to resemble its big U.S. brother, even if some of its managers still prefer to take more chances in search of the big payoff.By William Glasgall in New York, with Bill Javetski in ParisReturn to top