Is it better to invest directly into listed securities or into unlisted managed funds? There is no correct answer as it depends on your personal investment needs and objectives and, importantly, which strategy you are comfortable with.
The benefits of investing in shares
Why are shares so popular?
- Shares have historically outperformed all other assets classes over the long term.
- Shares can provide long-term capital growth.
- Shares can provide a strong and growing income stream.
- Tax benefits might be available via franked dividends.
What can change?
Change has been a major component across investment markets over the last 50-odd years. From the 'Black Monday' crash in 1987, to 18% interest rates in the late 80’s and early 90’s, through to the 1997 Asian crisis, the tech and internet stock boom and bust in 2000, and of course who could forget the GFC in 2008.
More recently, of course, investors are experiencing the impact of Coronavirus. In this respect, COVID-19 has had an impact on life in general, not just investment markets, which makes its disruption extraordinary.
Key points to remember
The market has never failed to rise above its previous high following a major correction. Shares are often considered risky due to potential short-term performance volatility. Over the long term, however, shares have provided consistent investment returns.
Shares are often considered risky due to potential short-term performance volatility. Over the long term however, shares have provided consistent investment returns.
Chart 1: Australian Shares (ASX200) vs Cash (90 day BB) : June 2000 to Feb 2021
Dividend yield & imputation credits
Many dividends paid to shareholders include 'imputation credits'. The imputation credit and resulting tax benefit available from the dividends means the actual return from a stock needs to be "grossed up" to reflect its true value.
A common mistake investors make is to compare bank rates with dividend yields. The cash rate is fully assessable whereas the dividend yield includes the imputation credits, so this tax concession should be taken into account. A 5% dividend yield would provide a similar return to a 7% bank rate.
Other tax issues
In addition to tax benefits arising from franked dividends, investors must also consider capital gains and/or losses and the tax implications as a result of investment decisions.
By investing directly into listed securities, it is the investor who controls the tax consequences of that investment.
That is, investments are bought and sold at the investor's discretion rather than at the discretion of a fund manager. Capital gains and losses can be managed to suit the investor's tax position.
In contrast, fund managers will usually turn over stocks within their investment portfolios (particularly Australian Equity funds) on a regular basis.
Distributions from managed funds include realised and unrealised capital gains or losses as a result of the higher level of trading, and is displayed as 'total return' . The investor has no control over the tax management of these distributions.
The resultant outcome generally means the investor has an unwanted or inconvenient tax consequence at the end of the financial year, which could have an impact on their overall tax position.
This lack of control is an influential factor that pushes investors to favour direct share investing over managed funds.
Access
One of the key advantages of investing in direct shares is the flexibility and liquidity it provides.
The ASX provides an environment for Australian investors to easily purchase or sell shares, or rebalance portfolios, in a timely and cost-effective manner.
The benefits of investing in managed funds
A managed investment combines an individual investor's money with the money of thousands of other investors to form an investment fund. Specialist investment managers then invest the pooled money on investors' behalf.
Benefits of managed funds
- Trained investment specialists: Constantly research and monitor investment markets to determine the best possible investment opportunities.
- Convenient and efficient: Paperwork and administration, regular information on the fund’s performance, annual tax statements and tax guides.
- Diversification: A truly diversified portfolio can be difficult for a direct investor to achieve. Managed investments make diversification easier.
Structure
Most managed funds are structured as unit trusts. When invested into the fund the investor's money buys units in that fund.
The unit price reflects the value of the fund's investments. If the value of the fund's investments rise, the unit price also rises. Conversely, if the value of the fund's investments falls, the unit price also falls.
Access
Managed funds provide access to investments in assets normally not available to individual investors (e.g. international emerging markets). Investing internationally via managed funds can provide greater diversification and investment opportunities compared to investing only in the Australian sharemarket.
The redemption process for managed funds is not as timely as it is with selling listed shares.
Fund managers must value all their assets at the prevailing market price. Depending on the unit price at the time of redemption an investor may be forced to sell a higher number of units to achieve a specific dollar value.
This means the portfolio's overall investment value is affected as there are less units remaining in the fund.
Dollar cost averaging via regular savings and compound growth
Investing in managed funds allows an investor to effectively reduce their investment cost (or capital) by dollar cost averaging.
Dollar cost averaging is simply purchasing investment units at differing prices on a regular basis (usually via a regular savings plan), which then reduces, or averages, the overall cost base of the investment unit.
This can help minimise potential capital gains tax when the units are eventually sold. Re-investing fund distributions into additional units provides a 'compound interest multiplier' effect.
That is, your investment capital benefits from the effects of compound growth as the distributions from your investment earn interest.
Diversification
Diversification of an investment portfolio across all asset classes allows an investor to 'hedge their bets'. By spreading the exposure and investing in different assets an investor can create a portfolio that can minimise to some degree the losses that may occur in one asset sector with gains in another.
The overall effect is that volatility is moderated, and investment returns can smooth out over time.
Investing in managed funds allows the investor to diversify funds over a basket of assets that may otherwise not be accessible. This is a key strength of funds as investors can spread their investments across a range of asset classes rather than having exposure to just one class.
The 'fee' factor
Having a team of specialist investment managers comes at a cost, as does the benefit of having an effective administration and reporting system. Fund managers can charge entry, exit, ongoing management and even performance fees.
Index fund managers traditionally charge lower fees than active fund managers as they have lower portfolio management costs. Retail funds are more expensive than wholesale funds, typically charging between 1-1.50% pa more.
An investor can access the cheaper wholesale funds, however, they must either have a larger initial investment (generally, from $20,000 up to $500,000), or they can invest via a platform (wrap) structure, which then charges its own administration fee.
It is this level of cost and complexity of fees that turn many investors away from investing in managed funds. Additionally, the level of fees charged by a fund manager can have a significant impact on the overall return of the investment, particularly over the long term.
So that like-for-like performance comparisons can reasonably be made between different funds, fund managers are required to display performance data as after-tax returns or 'net of fees'.
In conclusion
Regardless of preference, the winner here is the investor who can choose to invest in a manner that best suits his or her needs.
Whether direct investing is the preference or indirectly via a managed fund, the investor can decide based on their investment goals. A combination of both may be preferable so that the investor can fully appreciate the benefits of each strategy.
Understanding what you are investing in and why is the most important factor of all for any investor, regardless of how.
