Ship comes in

Offshore funds offer greater choice and value - but red tape and complexity also deter uptake. However, tax incentives and changes to distributor status rules could prompt an influx of funds for sale in Britain, writes Simon Hildrey.

There are more than 2,000 open-ended funds domiciled in Britain. Many people would say this is more than enough funds for investors to choose from and there is no need for the potential universe to be expanded.

This is a philosophy shared by many financial advisers. Asset managers say the main buyers of their offshore funds are discretionary and multi-managers, with financial advisers trailing far behind.

This is supported by research conducted by HSBC Investments. While HSBC found that 92% of advisers surveyed use offshore funds, the respondents said offshore funds comprise just an average of 11% of client portfolios.

Furthermore, Clark says that HSBC receives inflows into its Luxembourg funds from just 20% of the intermediary market.

Gary Marshall, managing director of Aberdeen Asset Managers, says Britain lags behind other European countries in the degree to which foreign domiciled funds are offered to investors. According to PwC, 51% of the funds offered in Britain have a foreign domicile. This is more than France (37%) and Spain (50%) but trails the likes of Germany (80%), Italy (76%) and the Netherlands (88%).

There are several reasons why many financial advisers have been cautious about including more offshore funds in portfolios.

One is that financial advisers and clients already have a wide choice of onshore funds. Advisers like Alan Steel, the managing director of Steel Asset Management, argue that there are plenty of good quality funds and managers among the onshore universe.

They say investors only need a handful of good funds in each sector to populate their portfolios. Even among US equity funds, which is a sector where advisers often bemoan a shortage of good quality funds, Steel highlights the Martin Currie North America and CF Richmond Core funds. "It is not necessary for UK investors to go offshore."

Other advisers point to managers such as Neil Woodford and Philip Gibbs as providing evidence of talented managers running onshore funds.

Furthermore, most equity funds that are bought invest in British equities. It is unlikely that offshore managers will specialise in British equities, and for this sector investors will tend to focus on onshore funds.

Supporters of offshore funds, however, argue there are also many mediocre onshore funds. If advisers and clients only focus on the consistently good performers, the universe of choice becomes much smaller.

The offshore market has its share of mediocre funds as well. If the potential universe is widened to include offshore funds, however, the opportunity to choose good quality managers and funds becomes greater.

As Andy Clark, managing director of wholesale at HSBC Investments, says, "Do financial advisers really believe all the best investment talent is managing onshore funds?"

"There are plenty of examples of good quality offshore funds. These are not only managed by well-known names in the British fund market but also by asset managers and boutiques with no presence in the retail market in this country. They include Ashburton, Findlay Park, Goldman Sachs Asset Management, ING Investment Management, Intrinsic Value Investors (IVI), Nordea Investment Management, Pictet Funds and Pioneer Investments. Robert Burdett, co-head of multi-management at Thames River Capital, says many boutiques set up offshore funds because of the ability to impose performance fees and cap the size of funds before it was possible to do so in Britain."

Clark also says advisers and investors are missing out on interesting investment opportunities of which the rest of the world is taking advantage. He points to the Luxembourg-based HSBC GIF Indian Equity fund, which Clark says is the largest fund in this sector in the world with about $4 billion (£2 billion) in assets.

"The size of the fund reduces the total expense ratio (TER)," says Clark. "We could set up a UK onshore fund but it would cost us money to do so and would be more expensive for investors."

This is a point reiterated by Paul Gaston, UK sales director of Pictet Funds. He says most of the €3.2 billion (£2.5 billion) in assets in its Luxembourg-based Water fund have come from continental Europe rather than Britain. "We believe that UK investors are missing out.

"We have a number of thematic funds in Luxembourg. They include the Clean Energy, Generics, Latin American Local Currency Debt, Premium Brands and Security funds.

"Over the past year, asset managers such as New Star, Schroders and Fidelity have launched thematic funds that have been based offshore rather than onshore.

"It should not be an issue of charges. The charges on our offshore funds are in line with those for onshore funds. The annual management charge on our standard equity funds is 1.20% and it is 1.60% for our thematic funds."

An increasing number of asset managers and funds will only be available offshore in the future. A boutique manager, for example, is unlikely to domicile funds in the UK as well as Dublin or Luxembourg.

The same goes for large asset managers. Why will they launch British based funds if they want to distribute in more than one country? They will establish or expand their Dublin or Luxembourg ranges and distribute these in Britain. Luxembourg Sicav funds, for instance, are well established in Asia as well as Europe.

"There is no reason for us to launch an onshore fund range and double up on our funds," says Gaston. "It can be more cost-effective for asset managers and investors when groups have just one fund range in Luxembourg or Dublin."

More than one sales director has said that if their asset managers could start again, they would not have a UK-domiciled range of funds but only have Dublin or Luxembourg funds.

Another trend is for asset managers to launch funds in Luxembourg or Dublin before offering a UK domiciled version. This is particularly the case when asset managers are uncertain about the level of demand.

"In such a situation, it makes sense for an asset manager to offer a fund in a number of markets rather than just the UK as this way they can be more confident about reaching the level of assets they want," says Darius McDermott, managing director of Chelsea Financial Services.

"For example, Fidelity, HSBC Investments and JP Morgan all managed offshore India funds before any onshore funds were launched."

Other examples include the Schroder AS Agriculture fund and Allianz RCM Global EcoTrends, which was launched in Luxembourg before being offered as an onshore fund.

McDermott says this shows new investment themes may appear first as offshore funds before coming onshore. Single country funds, such as Taiwan, may only ever be offered offshore.

Funds may be launched offshore for tax reasons. The New Star India fund is domiciled in Luxembourg and invests through a Mauritius company for capital gains tax (CGT) reasons.

Even when it appears there are onshore and offshore versions of the same fund, there can be attractions in investing offshore. If the offshore fund has fewer assets, for example, it may have greater investment flexibility.

Kevin Scott, executive director international of Jupiter, highlights the Luxembourg-based Jupiter Emerging Europe Select fund, which has about £100m in assets. He says that because of the fewer assets, this fund has a greater number of small cap stocks than its onshore version.

"The charges for the offshore fund are higher than the onshore version but some investors like the fact it has greater small cap exposure."

Of course, this advantage can also favour onshore funds over the offshore version. Advisers and investors may benefit by checking the difference between them.

Asset managers can be cautious about marketing offshore funds where they have the same onshore version, however, so they do not contravene treating customers fairly (TCF). They have to decide if it can be justified to market the offshore fund ahead of the onshore version. Of course, if advisers and their clients start looking at offshore funds, the potential universe expands massively. There is a question mark over whether advisers and investors have the time and resources to continually analyse and evaluate thousands of offshore funds in addition to more than 2,000 open ended onshore funds.

Advisers and investors, however, do not have to trawl through all the funds domiciled in Luxembourg and Dublin because they will concentrate on funds that are authorised for sale in Britain and have distributor status.

Authorisation for sale is granted by the Financial Services Authority (FSA) while gaining distribution status from HM Revenue & Customs (HMRC) is also important because it affects the tax treatment of offshore funds.

To gain distributor status, offshore funds have to pass several tests, including the distribution of 85% of their income to investors. These distributions are taxed at the British investors' marginal rate of income tax.

The attraction of distributor status for offshore funds is the fact that investors pay capital gains tax (CGT) on capital growth, which is now a flat rate of 18%. In contrast, capital growth from non-distributor status funds is subject to income tax, which is 40% for top rate taxpayers.

Furthermore, investors in distributor status funds benefit from the annual CGT allowance, which is £9,600 for each adult in the 2008-09 tax year.

The government amended the rules in the 2005 Budget to make it easier for funds to gain distributor status. This included abolishing the rule that every sub-fund and share class within an umbrella structure must qualify for distributor status. Now individual funds can gain distributor status.

Investors should have an even larger universe of offshore funds from which to choose after the government amends the distributor status rules from 2009. As part of the 2008 Budget, the government revealed funds will be able to report their income rather than distribute 85% of it.

It is not just a matter of time or resources that stops advisers and their clients from using offshore funds. It is argued the use of offshore funds has not become more widespread among advisers because of a lack of visibility.

This is particularly so because of the relatively small number of offshore funds on platforms and that they are not included in Investment Management Association (IMA) sectors and therefore performance tables.

"There has been interest in our offshore funds but it has primarily come from discretionary managers and multi-managers," says Philip Childs, head of UK retail at Ashburton. "Offshore funds need greater visibility.

"I have been asked where financial advisers can find offshore funds. Financial advisers are interested in boutiques but we need the greater visibility that being included in IMA sectors would provide."

This point is supported by Mark Dampier, the head of research at Hargreaves Lansdown. He says one of the most important factors in intermediaries and investors increasing their use of offshore funds are the funds being included in IMA sectors and therefore performance tables.

"I recently saw Kotak, which manages a multi-cap India fund," says Dampier. "I told them that if their fund returns 80% over the next year but is not in the IMA sector and performance tables, they will receive fewer inflows than Jupiter even if the latter's fund returns 50%."

Janet Walford, the editor of Money Management magazine, says that for the past three years it has compared the performance of onshore with offshore funds in the same sectors. Walford points out the magazine is comparing like for like as the offshore funds are sterling denominated and FSA recognised. Few other publications, however, ever make such comparisons, which do not help the visibility of offshore funds.

The Performance Category Review Committee (PCRC) of the IMA agreed in 2005 to incorporate offshore funds in its sectors. The IMA established a pilot project to test the feasibility of doing this and a working group was set up to help with the process.

The first stage came at the start of 2007 when the IMA began publishing sales data on those offshore funds that are registered for sale in the British market. New offshore funds are continually being added to these data. In April 2008, 620 offshore funds offered by 24 asset managers had £16.4 billion under management.

These sales data are shown in aggregate form that is separate from the IMA sectors. In May 2008, the IMA wrote to asset managers asking them to supply the data for funds to be included in IMA sectors. The IMA says it is unlikely that offshore funds will be incorporated by the end of this year, however.

Even when offshore funds are included in IMA sectors, however, this will not provide a solution for all asset managers. Childs says the sectors will only include offshore funds offered by managers that are members of the IMA. "To become a member of the IMA, we will have to establish a UK-based authorised entity.

"Another option is to launch UK domiciled versions of our Jersey funds. But if we do this, we will not be able to benefit from the track record we have built up for our offshore funds. It can take a track record of at least 12 months and in some cases as long as three years before IFAs consider buying them."

Another barrier to the greater visibility of offshore funds is the difficulty most of them have had in gaining a place on the leading platforms. While Hargreaves Lansdown's Vantage platform recently added 22 offshore funds managed by Pictet Funds, Cofunds and FundsNetwork have been more cautious in adding funds.

For example, Cofunds' website says it has 18 offshore funds on its platform, all of which are domiciled in Luxembourg. The first offshore funds were added to the platform in early 2007. Asset managers see the lack of offshore funds as a key barrier because an increasing number of financial advisers use platforms for most of their fund purchases.

Platforms argue they would add more offshore funds if there was greater demand. Cofunds says offshore funds account for just 1% of inflows into funds on the platform. FundsNetwork also says there is little demand for offshore funds from its core IFA customers.

So far, say platforms, most of the demand has been for specialist offshore funds. For example, the funds available on Cofunds are dominated by emerging markets and property funds. Platforms do say they expect demand for offshore funds to increase, however, especially as a growing number of asset managers are likely to launch sterling share classes of offshore funds rather than onshore versions.

Despite this optimism, this is a chicken and egg situation. Platforms will only add offshore funds when there is sufficient demand. But will demand increase when not many offshore funds are on the platforms?

According to Clark, platforms say there are other reasons why they have not included more offshore funds. "Platforms say that linking with offshore funds takes up more administrative time than onshore funds, there are currency issues and different dealing times. The platforms say they are doing well without having many offshore funds so they question if they need to bother."

Clark says these concerns are surmountable and says the demand for offshore funds is already there. He blames platforms for holding back demand for offshore funds. Recent research by HSBC (see box, page 23) suggests that 84% of financial advisers would use more offshore funds if they could access them through platforms and life companies. Encouragingly, 54% of advisers expect to put more money in offshore funds in the next five years.

This fits in with ever-growing lists of offshore funds being marketed in Britain. These not only come from boutiques and non-UK asset managers. Those groups with an onshore presence will increasingly launch offshore funds only, particularly for the non-core sectors and geographical regions, as they seek distribution beyond Britain.

HSBC offshore funds survey
HSBC's research was conducted with 50 investment-oriented financial advisers. Offshore funds comprise 11% of its clients' average investments, 92% use offshore funds and 54% expect to put more business in offshore funds in five years' time than today.

Of the 50 advisers, 52% said they would definitely put more money into offshore funds if they were available through life companies and platforms, while 32% said they would potentially. Interestingly, 70% said they and their clients would be more interested in offshore funds if they were more prominent in financial press coverage.

The most popular reason for advisers not putting more money into offshore funds was a lack of information, with 26% of respondents mentioning this. Other issues raised by advisers were regulation/tax (20%), not being appropriate for clients (15%), high charges (14%), higher minimum investment levels (9%), limited sales and marketing contacts (7%), poor/slow administration (6%), fund performance (5%), unavailable directly as an Isa (3%) and no fund platform availability (2%).

The most common source of information on offshore funds for the respondents are data providers, such as Lipper and Morningstar, with 34% highlighting this choice. Financial information providers, such as Bloomberg and Reuters, were selected by 23% of advisers and 22% mentioned the trade press.

View of multi-managers
It is common for multi-managers to use offshore funds in their portfolios. Tony Yousefian, chief investment officer of OPM Fund Management, however, says he tries to avoid using offshore funds. "It is not that we feel there is anything wrong with offshore funds, but we find it is not very quick to deal in most offshore funds.

"The application process for offshore funds can be quite long-winded. This includes forms for the administrator and custodian to fill out. It is the same when you invest and redeem from funds. We may want to invest in a fund quickly to be able to take advantage of a theme at an early stage."

Robert Burdett, co-head of Thames River Capital's multi-manager funds, says that the administration can be more time-consuming when investing in offshore funds. He adds that offshore funds trade at different times whereas onshore funds trade at midday. Nevertheless, Burdett says the investment advantages of offshore funds offset any administrative difficulties.

Among the offshore funds in Thames River's multi-manager portfolios is the Intrinsic Value Investors (IVI) European fund. "This is managed by Adriaan de Mol van Otterloo, who was previously at Schroders. He had two styles of management at Schroders. He was more comfortable managing the intrinsic value approach. He has a team of eight, who all used to work at Schroders as well.

"We like the JO Hambro Capital Management Japan fund managed by Scott McGlashan as he has a good record. We have held a number of offshore Asian funds, including funds managed by Prusik and Veritas Asset Management."

Jason Britton, fund manager at T Bailey, says its portfolios have included offshore funds over the past nine years. "We could not do our job as well as we do if we could not hold offshore funds. We continuously analyse offshore fund performance while offshore managers market their funds to us as well."

As an example of the investment opportunities provided by offshore funds he points to UOB Kinetics Paradigm. The fund is distributed by United Overseas Bank Singapore and the management is outsourced to Kinetics.

"This is a particularly attractive fund because the UK does not have an abundance of good performing actively managed US equity funds," says Britton. "We have also held the actively managed Vanguard US Opportunities fund."