What is the difference between managed funds and direct shares?

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.

With direct shares, the investor owns these shares directly. You buy these from the stock market and you sell them directly to the stock market.

These are the main differences between managed funds and direct shares:

Fees: There may be an upfront entry fee or an exit fee in a managed fund. 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 can also charge performance fees. This is the fee which the fund manager charges when their returns are over the benchmarked index. These fees are often 10% to 20% of the outperformance.

Direct shares incur a brokerage cost only.

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Redemption:  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 with a number of fund managers during the onset of the GFC.

Shareholders in direct shares can sell their holdings at any time and cash will be cleared into their account within two business of the transaction.

Taxation: 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.

Diversification: The number of stocks required for an optimal diversified portfolio is up to 20. In these managed funds, the number 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: There is less flexibility to liquidate stocks when needed in a managed fund compared to direct shares. Large 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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