Managed funds are an indirect way to own any or all of the three major asset classes, shares, properties and fixed interest, and the various derivatives of them. The managed fund industry is huge and much of its explosive growth has been driven by mandatory super contributions.
The industry directly and indirectly employs tens of thousands of people, from research analysts to marketing consultants to financial planners.
The managed funds industry, and its distribution network, the institutionally-aligned financial ‘planning’ industry, are big businesses and are getting bigger every year. There are more than 17,500 financial planners in Australia, and more than 80% of them are connected to financial institutions.
We do not like managed funds and recommend GPs do not invest in managed funds except for certain limited circumstances.
Most managed funds have not beaten the market average over the last 40 years, largely due to commissions and high operating costs. Even if a particular manager beat the market one year, it usually didn’t the next year. Picking successful fund managers is a challenging task. Few do it well.
What do we usually tell GPs to do?
Historically managed funds have not performed well. For example, as reported in the Sydney Morning Herald on 19 September 2012 that over the previous five years only 30% of actively managed funds beat the ASX average, and 70% didn’t. And that only tells part of the story: of those who did beat it, they did not beat it by as much as they should have, and those who did not beat it should have not fallen so far below index.
The under-performance is due to excessive fees. This includes fees to consultants, managers. and financial planners. Some of these fees are disclosed to investors and some are not. For example, few investors know about so called shelf fees. These are fees paid by product makers to AFSLs just to be listed on their approved product list, ie the list of financial products financial planners are allowed to recommend to clients. These fees get their names from similar payments made by manufacturers and distributors to super markets. Volume based shelf fees have been banned since 1 July 2013, but non-volume based shelf fees are still common.
Fees and costs reduce returns. Avoiding managed funds usually means avoiding higher fees.
We believe GPs should generally own direct investments rather than indirect investments because those who do get better returns over time than those who invest indirectly, particularly through managed funds.
The characteristics of direct investments
These characteristics include transaction costs, the ability to borrow against the asset, the form of the return (income and/or growth), price volatility, tax profile and the degree of specialist knowledge required.
Property attracts significant transaction costs. Stamp duty is the big-ticket item here, along with a plethora of smaller fees, such as titles office applications, solicitor’s fees, bank fees, etc. These can add as much as 5-6% to the acquisition cost of the asset.
Many GPs are surprised to learn that a $950,000 property bought at auction on the weekend breaks the $1 million barrier once these transactions costs are brought into the calculation.
Shares and other securities attract fewer transaction costs than direct property investments. Low-cost brokers and the abolition of stamp duty on share transfers mean that transaction costs on shares and other securities are small and can, in most cases, be ignored.
Direct investment transaction costs are transparent, and known. They are easily identified and rarely unexpected. This is completely different to indirect investment costs, which are often deliberately disguised, or even hidden, from the investor.
Ability to borrow
Historically, banks and other lenders have favoured property as security for lending purposes. However, this has changed in the past few decades, and lenders are now far more willing to accept shares (and some managed funds) as security.
Margin lending was particularly common up to the GFC and offered competitive interest rates. However, margin lending is now largely discredited and relatively rare. The interest rate and other costs and the risk of a margin call in a falling market are too high relative to alternatives.
The form of the return
Some shares and properties are expected to produce both income and capital gains, but some shares (eg, resource sector shares) and some properties (eg, undeveloped land) are only expected to produce capital gains.
The total return is the important issue here. Remember, unrealised gains are tax-free (or at least tax-deferred) and usually half of the realised capital gains are tax-free, so there should be a preference for capital gains, particularly unrealised capital gains.
Direct investment returns comprise:
- Interest on cash-based investments like term deposits
- Dividends and realised and unrealised capital gains on shares
- Rents and realised and unrealised capital gains on property
An asset’s price is volatile if it fluctuates over time. In the past 10 years, the most price-volatile assets have been international shares, Australian shares and property, in that order. Bank deposits and fixed-interest securities (provided they are held to maturity) will have no price volatility, as their price does not change over time.
International share prices are the most volatile because they are affected by a wide range of geo-political issues and movements in the exchange rate, ie, the Australian dollar expressed in terms of foreign currencies, particularly the US dollar.
Ranking property as less volatile than shares is an interesting step. Share prices can be measured objectively each day (and even each minute) by looking at the prices quoted on the Australian Stock Exchange. There is no equivalent facility for properties. Property prices can be estimated, but they cannot be determined accurately unless the property is sold.
Hence, comparisons of price volatility between shares and property have to be treated with some caution. It is possible that residential property is experiencing wild price oscillations; it is just that you do not know about it and you cannot measure it.
The tax profile of a direct investment can be important. For example, Australian shares generate franked (tax-paid) dividends, whereas international shares do not. Dividends must be compared on an after-tax basis not a before-tax basis for a true comparison. International shares need to earn more than Australian shares on a pre-tax basis to have the same after-tax rate of return.
(For this reason GPs should be very wary of international shares: the absence of franking credits compared to their Australian counterparts means these are unlikely to do better than Australian shares and are likely to do worse.)
Similarly, a large part of a property’s rent may be sheltered from tax due to depreciation and building write-off claims. This can influence the comparison between the after-tax rate of return on a property and the after-tax rate of return on alternative investments. These tax benefits can be significant and must be considered when choosing between alternative investments.
Using debt to buy a commercial property with high depreciation benefits and expected large capital gains is efficient from a tax point of view because:
- The interest incurred on the loan is deductible against other income;
- Some of the rent will be tax-sheltered by the depreciation and building write-off allowances; and
- A large part of the return – the unrealised capital gain – is tax-deferred and will not be taxed until the property is sold. The sale can be timed and planned to minimise tax payable on the half of the capital gain that is minimised.
Unrealised capital gains (gains on assets that have not been sold) represent just as much income as anything else. They represent an increase in benefits just as much as a salary payment or a
dividend, plus they have the advantage of not being taxed until and if they are realised (sold). The world’s most successful investor, Warren Buffett, describes the tax deferral benefit of unrealised capital gains as the equivalent of a interest-free loan from the government (see Part 7 of Buffett’s Owner’s Manual for Berkshire Hathaway).
It is important to understand the tax profile of an investment. You should also appreciate that tax benefits such as franking credits, depreciation and building write-offs and the deferral of tax on unrealised capital gains favourably affect the analysis of an investment.
Being able to control when a capital gain is realised is important for efficient tax planning. A capital gain distributed through a managed fund means that an investor has no control over when the capital gain is received. In fact, it is usually only after the end of a financial year that an investor may be informed that they will be subject to capital gains tax, even though they have not sold any units in the managed fund.
Some direct investments, such as high-tech shares, require a high degree of specialist knowledge. There are many examples of investors who lose on direct investments, and we confess to being very wary of investments like these. Warren Buffett retains his investing crown and his wealth by not investing in businesses he does not understand. He admits this means he has missed out on some good investments, but believes that, on balance, he is well ahead.
If this strategy is good enough for Buffett, it is good enough for GPs. Investing in something that you do not understand is the same as gambling, and unlikely to make you wealthy.
With direct investments into the share and property markets, there is no risk that an adviser will lose your money in reckless investments or in fraudulent activities because no advisers handle your money. Only you handle your money. You might still lose it – but it is better to suffer from your own mistakes than to suffer from someone else’s.
Advantages of direct investments
Direct investments have several advantages over indirect investments.
Returns tend to be higher because, unlike indirect investments, there are no commissions and management fees. Higher returns can also be due to the investor exercising sound judgement when deciding what to and what not to invest in.
The individual investor has more control over a direct investment. For example, they can decide to renovate a property and create extra value, whereas they have no control over the changes to a property portfolio if they own units in a property trust. An individual investor may also decide to place a property on the market at a high price (you never know your luck). This sort of thing cannot be done with managed investments.
Many GPs enjoy looking after their own investments. A semi-retired 65-year-old GP investor can enjoy spending 10-20 hours a week studying the share market and tracking the performance of their portfolio and alternative portfolios. Similarly, for some people the comfort of bricks-and-mortar investments with their name on the title and which they can see and touch with their own hands means a lot more than an ASX e-record saying they hold so many shares and are entitled to dividends.
Disadvantages of direct investments
The disadvantages of direct investments include:
- Lack of liquidity. This is really only a problem for property and is not an issue with exchange-traded shares. Properties can be hard to sell at short notice, although in many cases this can be overcome by arranging in advance debt facilities to be drawn on if cash flow is restricted. These facilities should be put in place even if they are not expected to be used, to ensure liquidity and flexibility.
- Lack of diversity. This generally means more risk, but it can also mean more up-side risk, which means a greater probability that the actual result from an investment will be greater than the expected result. Many GPs have been criticised for having too much of their wealth in property and a lack of diversification into other asset classes. This is a curious criticism because, with the benefit of hindsight, it has turned out to be an excellent strategy.
Increasing popularity of direct investments
Generally, in recent years there has been an increase in the popularity of direct investment. There are a number of reasons for this, principally the higher returns, the greater control and the enjoyment factors. Other factors include:
- Most fundamentally, a strong domestic economy with resilient and rising share prices and property prices, particularly compared to international conditions;
- A rising population, featuring well educated and well shod new arrivals with a strong work ethic and strong property hankerings;
- International demand for property, particularly from China. Some say Chinese buyers accounted for as much as one third of all property investments in NSW in 2013 and 2014, often paying record prices to acquire their slice of the market;
- Increased availability of quality information. There is more information out there than you could possibly absorb on all types of investments, and most of it is free of charge or relatively cheap.
- Government floats, particularly Telstra and the Commonwealth Bank, exposed huge numbers to direct share ownership. People who had never dreamed of owning shares suddenly found themselves shareholders, and they liked it. It gave them the confidence to widen their horizons by investing in other companies. The massive education campaigns accompanying the privatisations provided a lot of quality information to first-time investors.
- Improved share broker administration systems and the rise of internet-based brokers have removed most of the paper rigmarole connected to owning shares;
- Tax planning strategies involving negative gearing. The 2013 – 2017 boom in Sydney and Melbourne residential property prices has been partly attributed to people in their fifties and sixties gearing against the almost debt-free family home and buying one, two or more investments. Generally, and with the exception of some second-rate inner-city apartment developments, this has been a good move.
- Increased credit availability following banking deregulation in the 1980s and 1990s;
- Worldwide trend to lower interest rates and innovative funding arrangements. Twenty years ago, it was unheard of for banks to lend for share purchases. Not so today;
- Good investment returns on rising markets creates a wealth effect encouraging further debt-funded investment strategies from share owners and home owners; and
- Increased awareness that the old-page pension makes for a bleak existence and that individuals need to plan for their retirement.
Index funds are a form of managed fund. But they are very different from the others. They are low cost, and provide the simplest and cheapest way of making sure you get market rates of return.
We are happy to recommend index funds to GPs.
We routinely recommend GPs invest in index funds, particularly index funds based on the Australian share market, such as the Vanguard Index Australian Shares Fund.
We recommend GPs invest in index funds because:
- GPs have had great results with index funds over the last two decades;
- no GPs have lost all their money investing in index funds;
- no GPs have had their index funds “frozen”;
- no GPs have woken up to find their advisor has run off with their money (since clients invest directly into the index fund and do not need middlemen);
- Index funds do not pay commissions;
- the low cost structure means over time it is highly probable index funds will outperform actively managed funds in the same investment sector;
- they are simple and easy to understand;
- accounting is easy, keeping costs down even further;
- most GPs do not have the time, energy or inclination to be more actively involved in their investment strategies; and
- modern portfolio theory predicts managed funds will outperform most actively managed funds over time: its what the people who work for fund managers are taught in undergraduate courses and then forget when they get a job.
Index funds are a different type of managed fund. In fact, for reasons discussed below, the name ‘managed’ fund might be a misnomer. Index funds could be more accurately described as ‘administered,’ rather than managed. This is because the index fund manager tells investors exactly what it will do with money that they invest. The only management they provide is to act as a conduit between the investor and the share market.
What is an index fund?
An index is a number. This number represents the change in the value of a number of securities that have been grouped for the purpose of ‘measuring the market.’ A commonly quoted index is the ‘All Ordinaries Index’ (AOI). The ASX website defines the AOI as follows:
“The index is made up of the weighted share prices of about 500 of the largest Australian companies. Established by ASX at 500 points in January 1980, it is the predominant measure of the overall performance of the Australian share-market. The companies are weighted according to their size in terms of market capitalization (total market value of a company’s shares).”
So, when a presenter on the nightly news says ‘the All Ordinaries was up 0.6 of a percent today,’ what he means is that the top 500 companies on the exchange went up by an average of 0.6%. Some companies will have gone up by more than this, some by less. Some might even have gone down.
The AOI is the weighted average of the largest 500 shares.
The largest 500 shares account for about 99% of the entire Australian share market. Therefore, the AOI is basically the average performance of the entire market.
An index fund is therefore sometimes described as an investment in the stock market as a whole.
Indexing involves the fund purchasing a representative sample of shares, in accordance with the proportion of the index that company represents. For example, if a company’s shares make up 2% of the total value of the index, then the index fund will allocate 2% of its investment funds to shares in that company.
This strategy is often described as ‘passive’ because the fund manager does not try to predict the future performance of individual shares. Instead, the fund manager merely follows the market’s estimation of this future performance. This is because market share prices are essentially the sum total of the market’s expectation about the future performance of the company involved.
The opposite of passive management is known as ‘active management.’ Active management is where the fund manager deliberately tries to pick those stocks that will do well and/or avoid those that will perform poorly.
Other benefits of index funds
There are some other benefits of index funds that we like as well. These benefits come down to effective risk management. The way in which index funds help to manage risk include:
The predominant retail index fund in Australia is the Vanguard Index Australian Shares Fund (‘VIASF’). The VIASF tracks the ASX 300. To do so, it buys shares in approximately 265 companies traded on the exchange. (It does not hold shares in the smallest 35 shares in the ASX 300, as these shares make up such a small component of the index that holding them would not affect the return).
This represents optimum diversity. While it is a given that the 265 shares that are held will include some lemons, most of the shares will perform well over time (using history as our guide).
Remember the long-term average of 7.5% plus inflation was for the average Australian share. The more shares you own, the more likely you are to get the average.
It would be virtually impossible for any individual to own shares in these 165 companies in their own right. The administrative and brokerage burden would be too great. Therefore, the index fund offers the most efficient (in terms of time and money) means of owning a diversified fund.
This automatic diversity is actually a feature of most managed funds. But because we think index funds are better than other managed funds, we think they are the best way to achieve this diversity.
Diversification allows the investor to manage what is known as specific risk. Specific risk is the prospect that a particular share will perform poorly. The index has more than 200 shares, which means the effect on the entire portfolio of one share performing poorly is minimal.
Ease of management
In addition to automatic diversity, index funds also facilitate easy management. One of the main arenas in which we see this advantage is where a SMSF is used. At the end of the financial year, the index fund manager will provide the investor with a short summary of all the transactions during the year. The summary will also show how the information should be accounted for. A SMSF has to be audited and accounted for each year.
The information provided by the index fund manager makes the accounting and auditing task a lot less time-consuming. And because accountants and auditors charge according to time, the accounting and auditing fees are a lot cheaper. This provides a ‘double whammy’ effect: not only is the index fund the most efficient way of accessing the markets; the associated costs are minimised as well.
Index fund returns get better with age
Forbes Magazine carried an article on 4 April 2013 by Rick Ferri and captioned “Index Fund Returns Get Better With Age.” The article discusses USA studies demonstrating over time index fund returns are more likely to achieve better returns than actively managed funds.
The studies show that over a 40 year period the number of actively managed funds that beat the index fell from 40% over 1 year, to just 12% over 40 years. Remember, one would expect 50% to beat the market every year, so even 40% is a statistically significant under-performance.
The 40 year position is graphed here:
The increasing under-performance over time has two main causes. These are:
- The compounding drag of higher management fees over longer periods. Actively managed fund expenses are about five times greater, and over time this significantly depresses accumulated earnings; and
- The high volume of fund closures and mergers: poor performing funds are usually closed down. Over the 40-year period nearly two thirds of all managed funds were shut down due to poor performance. When the historical data is adjusted for this “survivorship bias” the true under performance of actively managed funds
There is nothing to suggest that the USA experience is not replicated in Australia. In fact Australian managed fund costs are generally higher than USA managed fund costs, and this means it is likely that the under-performance over time will be even greater than in the USA.
Index funds and dollar cost averaging
Index funds lend themselves to a simple strategy known as “dollar cost averaging”.
Dollar cost averaging involves regularly buying the same dollar amount worth of assets. For example, on the first day of the month the GP might invest $1,000 into the index fund – regardless of the price on that day. Because the GP is investing the same amount of money each time, the number of units will vary according to the price on the day of purchase.
GPs using dollar cost averaging will buy a greater number of units when the price is lower, and a lesser number of units when the price is higher. This usually skews the average cost within the portfolio downwards. Hence, dollar cost averaging usually allows the GP to reduce the average cost of units over time.
Some commentators do not like dollar cost averaging. But we do, particularly with lower risk assets such as index funds. This is because:
- investing a smaller amount regularly over time, using a line of credit, is easier than investing a large amount at one time; and
- it’s hard to beat the market by timing entry and exit perfectly; and
- index funds, with their high diversification and low risk, are suited to long term investing strategies particularly if some debt is being applied.
For example, Neil Hartnett in Introduction to Individual Financial Planning (Pearson 2009) recognises points (i) and (ii) above are good, but observes that if the investment falls in price the investor has lost money no matter how or when the investment was acquired. Neil is right, and we agree wholeheartedly. This is why we say the target investment should be units in an index fund and the holding period should be very long term, measured in decades not years, and even generations.
Disadvantages of index funds
Index funds do have some drawbacks. These are discussed in the following paragraphs.
Some GPs prefer to not invest in companies involved in certain activities. Gambling, alcohol, mining, timber etc are commonly avoided by what are known as ‘ethical investors.’
Index funds, almost by definition, cannot avoid these types of company. So, an investment in an index fund that seeks to track a substantial index such as the ASX 300 will include shares in companies that the investor might like to avoid.
Some investors get around this by quantifying the amount of their return that is attributable to the undesirable companies and offering this amount to charity. For example, the investor might calculate that they made $500 from their investments in gambling companies, and donate this amount to gambling helpline or similar (some state governments claim to do the same thing!). But of course, doing this reduces some of the advantages of the indexing approach.
Cannot possibly beat the Index
The index fund cannot possibly outperform the index. We have actually heard a financial planner describe them as un-Australian for this reason, asking what Australian would make of a cricket team that happily accepts average performance(this was back in the day of Gilchrist and co!).
If you want your investments to beat the market, steer clear of index funds. As to where you would go: we don’t really have a clue. Happily, we are quite happy to admit what we don’t know, because it puts us in fine company. One of the reasons we like index funds is that they come recommended by none other than Warren Buffett, often described as the world’s most successful investor. In 1993 he said:
“By periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when “dumb” money acknowledges its limitations, it ceases to be dumb.”
Nothing has changed since then. Anyone who followed this advice over the last thirty years would have beaten most fund managers, and we expect anyone who follows this advice over the next thirty years will beat most fund managers too.
So index funds are a happy exception to the rule against GPs investing in managed funds.
At the 2004 Berkshire Hathaway shareholders’ meeting Buffett was asked whether investors should buy Berkshire, invest in an index fund, or hire a broker. Buffet responded: “We never recommend buying or selling Berkshire. Among the various propositions offered to you, if you invested in a very low cost index fund — where you don’t put the money in at one time, but average in over 10 years — you’ll do better than 90% of people who start investing at the same time.”
“If you like spending 6-8 hours per week working on investments, do it. If you don’t, then dollar-cost average into index funds. This accomplishes diversification across assets and time, two very important things.”
“Just pick a broad index like the S&P 500. Don’t put your money in all at once; do it over a period of time. I recommend John Bogle’s books – any investor in funds should read them. They have all you need to know. Vanguard. Reliable, low cost. If you’re not professional, you are thus an amateur. Forget it and go back to work.”