Managed Funds are a way to own shares without having to select the individual shares yourself. It is a way to pool all investors in a group and share the benefits together. You buy units in the fund from the fund manager and sell these units back in the future to this fund manager.
This industry has exploded with many to choose from but for the last 40 years most managed funds have not beaten the market average. The predominate reasons are the management fees and high operating costs.
We have listed below the reasons why direct shares could be a better investment than managed funds:
Lower Returns: A study conducted from the SPIVA score card identified some interesting figures:
From the table below, we can see that the return of direct share ownership outperforms managed funds. Even some household name stocks have done very well. If you held MQG (Macquarie Group) for 3 years you would have returned 48%, if you held NST (Northern Star) you could have returned 241 %. The average return of 8 Australian indexed managed fund only returned 6.14%.
Fees: There may be an upfront entry fee or an exit fee. Some funds may also have a trailing commission fee to financial planners at 0.5% per annum. All funds charge a Management Expense Ratio (MER) which is about 0.7 per cent to 2 percent with active managers charging a higher fee. Managed funds also charge performance fees. This is the fee which the fund manager charges when their returns are over the benchmarked index. These fees are a whopping 10% to 20% of the outperformance.
Redemption issues: If there is a hoard of investors wanting to withdraw their money from the managed funds, the fund manager may need to sell their liquid assets to keep up with all the withdrawals. To prevent this from happening, they may choose to freeze any redemptions. This happened recently to the UK property funds during Brexit. These funds halted withdrawals as too many people were taking money out simultaneously.
Taxation issues: With direct shares, you can use your franking credits from your dividends to reduce your tax payable. In a managed fund, there are unknown tax issues as funds do not need to disclose their potential tax liabilities. Units which you buy may inherit tax liabilities on gains which you did not benefit from. Also you cannot use the capital losses in a managed fund to offset capital losses you have outside of the fund.
Over diversification: The number of stocks required for an optimal diversified portfolio is 30. In these managed funds, the amount of stocks they hold can be anywhere between 30 – 100. Diversification can reduce risk but holding more than 30 stocks does not further reduce your risk, it rather often leads to bad returns.
Flexibility: Another issue with having managed funds over direct shares is the flexibility to liquidate stocks when needed. Big fund managers such as Platinum Asset Management manage about A$23 billion. They hold large positions in stocks so if a stock goes pear shaped, they may find it difficult to liquidate all their positions. As an individual investor with a smaller holding, it would be easier to sell your position with a simple call to your stock broker. Fund managers may also have mandates which require them to hold a certain percentage of cash in their funds. As an individual investor, you choose how much cash you want to hold in a trading account. In a bear market, you may want to hold a significant portion or the whole portfolio in cash. This choice would not be available in a managed fund.
Lauren Hua is a private client adviser at Fairmont Equities.
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