Why you should not invest in managed funds

Blog - 24102013With around 85% of financial advisers affiliated with product providers, it’s not surprising that managed funds are recommended to clients more than any other investment type.

But are managed funds really the best investment for the majority of people? How do they stack up against investing directly?

As a basis for comparison, the Australian share market makes the most sense. Property, of course, is another option but is generally less accessible due to the higher price of entry, transaction costs and the need to obtain finance and various insurances. Managed funds and shares on the other hand can be accessed with smaller sums of capital and trigger few, if any, transaction costs upfront. Both are therefore very accessible to the average punter.

Arguably, the biggest advantage of managed funds is the ability to get started with very little capital, as low as $500-$1,000 in some cases. Furthermore, once the investment is up and running, regular contributions can usually be made with as little as $100. To put these numbers into context, a managed fund would typically have exposure to 50-500 companies and may be diversified over other asset classes too. Managed funds therefore provide considerable diversification for very little capital outlay. The share market, by comparison, typically requires a $500 minimum investment for each company purchased.

Beyond this, however, the benefits of managed fund investments become more difficult to identify, at least when compared to investing in the share market.

Management fees are the first issue. These are seldom mentioned when markets are rising but when asset values are going backwards, suddenly they become a point of focus, and for good reason because if your investments aren’t making money, the management fee is deducted from your capital, thus compounding your investment loss. Investing in shares directly, on the other hand, does not incur any ongoing management fees – only brokerage when a buy or sell is made. This means a managed fund investment may experience greater losses than a share investment during times of market decline and the greater the loss, the longer the recovery time.

Managed fund advocates will argue that ongoing management fees are justified because compared to a direct portfolio of shares, a managed fund is typically more diversified and greater diversification equals less investment risk. Additionally, they will be quick to point out that highly-skilled experts are managing your money which increases the likelihood of superior investment returns over a direct share portfolio. These are valid points, on face value at least.

Diversification is an important consideration for any investment portfolio and it’s no secret that spreading your capital over a range of assets and industries will assist to smooth-out the price volatility of a portfolio, but there is a misconception that the benefits of diversification are infinite. So what’s the reality? Well, if you keep adding investments to a portfolio you will reach a point of being over-diversified and this can reduce portfolio returns and actually increase risk.

To explain this in terms of the share market, there are two kinds of risk that exist for investors; systematic risk and unsystematic risk. Systematic risk affects the entire market and cannot be avoided through diversification (e.g. war, recession). Conversely, unsystematic risk is specific to a specific company or industry and can be reduced through diversification (e.g. declining commodity prices).
To maximise diversification (or reduce unsystematic risk as much as possible), you only need to invest in 5-15 companies. That’s all. Not hundreds like fund managers would have you believe. Every company has its own risk-factors so if you keep adding them beyond the point of maximum diversification you are increasing your systematic risk exposure and the likely effects of this are increased portfolio volatility and diluted investment returns.

Performance-wise, it is true that a small number of fund managers are able to consistently outperform their chosen benchmark (usually an index such as the ASX200), but the majority do not. In fact, history shows that if you buy the ASX20 (the top 20 companies) in equal proportions and do nothing else but reinvest the dividends, you will outperform the majority of managed funds more often than not. This result is even more compelling once you consider it is achieved in the absence of any research to determine the best companies to invest in and how much to pay, and excludes the effects of strategies to protect capital and time entry and exit points into the market.

Benchmarks are another limitation for managed funds. All fund managers seek to outperform an index over a period of time, typically 3-5 years. However, the problem with index benchmarks is that most fund managers are mandated to only invest within the index. This means they cannot access companies outside the index regardless of market conditions. This clearly isn’t an issue when investing directly and essentially means more opportunities to reduce risk and increase returns are on offer.

Buying the right companies is clearly an important starting point to maximise profits, but the prices at which acquisitions are made are of equal importance. Investing directly allows you to take advantage of the market’s liquid nature and determine the exact price at which you buy a company. Additionally, you have complete control over when to sell later and can tailor this to suit your profit objectives and tax position. In contrast, managed funds provide no means to time market entry and exit points and control profit and tax outcomes.

The final blow for managed funds relates to treatment of franking credits. If you invest directly, the full benefit of all franking credits received can be derived. To illustrate, this means if you receive $5,000 of credits, you can offset your tax liability by $5,000. The problem with franking credits within managed funds is that the credits are paid to the fund manager, not to you, and seldom do they pass all the credits on to investors. Typically some credits are passed on but most are retained in the fund and used for further acquisitions. Only those credits passed on can be used to reduce your tax bill. It should be noted however that retaining some franking credits for further investments (in the mandated index) might suit some investors, but most will benefit more from reducing their tax bill.

So unless you have a small amount of capital to invest, investing in the share market makes for a better investment than managed funds. Direct share investment provides unlimited investment choice, more flexibility and control, greater opportunities to manage risk and diversification and is more tax-effective.

If only the majority of financial planners weren’t incentivised to recommend managed funds…

This advice may not be suitable to you because it contains general advice that has not been tailored to your personal circumstances. Please seek personal financial and tax advice prior to acting on this information. Opinions constitute our judgement at the time of issue and are subject to change. Financial Planning Expert Pty Ltd does not give any warranty of accuracy, nor accept any responsibility for errors or omissions in this document.
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