There is a fundamental problem with managed funds that are costing investors their long term returns.
A managed fund (or mutual fund in the US) is a professionally managed investment fund that pools money from many investors to purchase securities.
My Experience: The Problem with Managed Funds
In my time as a professional financial adviser I have seen countless numbers of clients and potential clients with managed fund holdings that haven’t made them any money.
These clients didn’t just buy their managed fund yesterday, in some cases clients have held their managed fund for 10 years or more.
Let’s take a look at why managed funds become poor long term investments.
Problem: Tax Structure
Managed funds are arranged in a unit trust structure.
So as opposed to you buying shares directly from the Australian Stock Exchange (ASX) as follows:
You instead pool your money with many other investors and have this funds managed by a professional fund manager in a tax structure known as a unit trust:
A large unit trust could contain hundreds of thousands of investors each holding a number of units that corresponds to their interest in that managed fund.
When comparing a direct investor to an investor in a managed fund, the managed fund investor is one step removed.
Why Is This Good?
- You can start investing with a smaller amount of capital
- You have a professional fund manager making investment decisions
Why Is This Bad?
- The fund cannot distribute losses
- You can’t elect to take control of the underlying shares owned via the unit trust
- You are in the dark about the running tax position of the fund
- If the fund suffers large redemptions, remaining investors lose out
The running theme of the abovementioned issues is that you have no control over the underlying assets and this is an issue because it results in poor after tax outcomes.
Case Study: Perpetual Industrial Share Fund
To conduct a performance analysis we have chosen the Perpetual Wholesale Industrial Share Fund
We chose the Industrial Share Fund simply because it is relatively popular amongst investors (it managed over $2 billion as at March 2016) and it has been around for coming up 20 years this year (it started in December 1996).
Please be aware we are not singling out Perpetual’s fund, rather it is a randomly selected representation of the problem with the managed fund structure. Provide me with almost any other managed fund in Australia and I could show you very similar results.
The Market Performance
To provide data to compare the performance of the Perpetual Industrial Share Fund we are using the ASX 200 index. The ASX 200 Index is a value weighted representation of the largest companies listed on the Australian Stock Exchange and is the most common performance ‘benchmark’.
As you can see in the chart below the ASX 200 index has had a relatively choppy ride but has still recorded a return in excess over 121% before dividends.
Fund Advertised Performance
The advertised performance of the Perpetual Industrial Share fund, from the website is extracted as follows:
Let’s face it, this table is pretty confusing and doesn’t mean much to the average investor.
Fund Actual Performance
Below we have reconstructed the actual performance of the Perpetual Industrial Share Fund over 10, 15 and 20 year periods.
In all examples we have assumed we purchased 10,000 units to start our investment.
Comment: We beat the market, but our capital gain is negative and the bulk of the return was income.
Comment: We beat the market, but again our capital gain is negative and the bulk of the return was income.
Comment: We beat the market, but again our capital gain is minimal and the bulk of the return was income.
Please note we don’t have a benchmark available for the 20 year period (the previously used STW only listed in 2001)
The common theme over these performance periods was that our capital gain was low, while the bulk of the performance came as income.
Unit Trust Structure: Too Much Income is a Problem
There are two ways we can make money from share investments:
- Capital gains from selling a holding
- Income from dividends
Our tax system encourages people to invest in assets for the long term by offering a capital gains discount of 50% if you hold your investment for a period of more than 12 months. Due to the discount available long term capital gains are favored by investors.
Tax: Best Type of Return
Different types of investment returns are ranked according to their tax outcome for the average investor:
- Long term capital gain (held over 12 months)
- Fully franked dividends (dividends from most Aussie shares)
- Tax deferred distributions (distributions from property trusts)
- Foreign income, non-franked dividends & short term capital gains.
(1 being the most favored, 4 being the least favored)
The problem with unit trusts is that fund managers don’t take into account the tax outcomes. Fund managers don’t focus on long term capital gains; they focus on the short term returns of the fund.
Short term returns often equate to a lot of turnover in the portfolio or, in other words, the fund manager is actively trading your money.
The problem with a high level of trading is that much of the capital gain realized is on short term trades (i.e. investments held under 12 months) and tax has to be paid by the underlying investor (you).
Managed Fund – Tax Guide
Let’s take a quick look at an example of a tax statement from Perpetual.
As you can see there are a range of forms of income, which correspond to different sections in a personal tax return.
Perpetual Industrial Fund – Last 5 Years Distributions
If we take a closer look at the Perpetual Industrial Share Fund’s last 5 years worth of distributions we can see it is a mix of franked income, punctuated by large distributions in the other column.
If we take a closer look at the other column in July 2015 and July 2014, we can see that the bulk of the other income is made up of non-discounted capital gains – this is another way of saying short term capital gains (the least preferred source of investment returns).
The problem with managed funds are as follows:
- They are not transparent (you are one step removed from the underlying shareholding)
- They do not manage for your preferred tax outcome
- Our case study showed an example of a managed fund that paid out large amounts of short term capital gains.
Have you had a similar experience with your managed fund investments?
M.TaxFP, LLB(Hons), B.Bus(Acc), FTI, Adv.DipFP, Dip.FP, SMSF Specialist
The information on this blog and website is of a general nature only. It does not take into account your individual financial situation, objectives or needs. You should consider your own financial position and requirements before making a decision. We recommend you consult a licensed financial adviser in order to assist you.