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Study: too many hidden costs in Asia funds

Fund investors in Hong Kong and Singapore benefit from zero tax, but suffer from embedded costs, according to a Morningstar report.

Many countries exempt investors from capital gains tax while they hold a mutual fund, but tax at least some of the fund’s income. However, only Hong Kong and Singapore do not tax fund investors at all.

Yet, despite their generous tax regimes both territories only receive “average” ratings in Morningstar’s most recent Global Study of Regulation and Taxation in the Fund Industry, released on Tuesday.

Embedded — and often undisclosed — fees and costs inherent in their fund distribution models are the reason for lagging behind higher-rated fund industries in the UK and Europe.

Fund sales in Hong Kong are dominated by intermediaries, especially banks. Investors typically bear distribution costs through retrocessions (trailer fees paid by asset managers to intermediaries) included in the total expense ratio that they pay when buying a fund.

“Therefore, while Hong Kong investors can choose freely between open-end funds and exchange-traded funds, distributors have incentives to recommend open-end funds over ETFs because of the embedded commissions,” said the report.

Furthermore, soft-dollar commissions (whereby a fund trades with a brokerage firm in return for goods or services) are allowed by Hong Kong’s Securities and Futures Commission, and funds do not have to disclose third-party research costs in the total expense ration paid by the investor.

Permissive soft-dollar commissions are also common in Singapore, while the costs of distribution (retrocessions paid for out fund assets by investors) can make up 50% of the total expense ratio, according to Morningstar, an investment research firm.

More positively, both Hong Kong and Singapore encourage personal investing through mandatory retirement savings schemes.

The study, which was concluded before the Covid-19 pandemic, examined publicly available open-end funds and exchange-traded funds in 26 countries. It is one of four chapters in Morningstar’s Global Investor Experience, and it follows the fees and expenses chapter published in September 2019.

In the regulation and taxation chapter, Morningstar evaluated markets based on four key categories: policy and tax encouragements that incentivise individuals to invest for their futures, regulatory requirements for operations and distribution, governance, and regulatory structure.

The methodology assigned more weight to regulation of fund operations and distribution than in its five earlier studies. The change contributed to a greater mix of higher and lower grades around the average grade than previously, according to Andy Pettit, Morningstar’s director of policy research, EMEA, and co-author of the study.

“[However] since our last report in 2017, the trend towards strong regulation that protects mutual fund investors has remained intact,” said Pettit in a statement.

Average Asia

Elsewhere in Asia, Taiwan scores an “average” rating, winning plaudits for a “meaningful” tax allowance on investment income and no capital gains tax on onshore funds, but receiving brickbats for soft-dollar commissions and ongoing retrocessions.

Meanwhile, investors in Thailand’s fund industry have access to multiple tax-advantaged accounts, but also pay distribution costs within a fund’s total charges and have to put up with soft-dollar commissions.

China slips to “below average”, because of the shortage of alternative fund options and a failure to introduce mandated supplementary defined contribution pension schemes, as well as weak regulation of third-party research costs and soft-dollar commissions.

So, overall Asia’s report card was mixed.

“The majority of Asian markets benefit from low or nil taxes on investments and of the 26 markets, Hong Kong and Singapore are the only markets that do not tax fund investors at all,” said Wing Chan, Morningstar’s director of manager research practice, Emea and Asia.

“There were also positive developments on the regulations of fund distribution, such as the disclosure of trailer fees and restricted use of “independence” by advisers in Hong Kong,” he added.

However, “Asian markets can do better by enhancing the disclosure on third-party research costs and voting on shareholder resolutions, as well as the unbundling of distribution costs from fund fees,” said Chan.

In the rest of the world, the Netherlands, Sweden, and the UK earned top grades in part because they provide strong incentives for ordinary people to invest, although none of the countries offer the best tax systems for ordinary investors. Moreover, every European country covered by the Mifid II regulations earned at least an average grade as the regulation spurred needed reforms in areas like soft-dollar commissions and increased transparency.

On the other hand, Australia, Canada, New Zealand, and the US lagged other markets, because they fall short of the standard set by other markets that govern conflicts of interest and incentivise investing. In addition, Australia, Canada, and the US have less supportive tax policies compared with other markets, creating distortions and disincentives to invest, according to Morningstar.

Morningstar Regulation and Taxation Scorecard


Part of the Mark Allen Group.