Introduction
What is a managed fund and how does it work?
Why invest in managed funds?
Types of managed funds
Risk and return
Diversification and risk
Managed fund costs
How are managed fund returns determined
Tax: the hidden cost
Types of fund managers
Why consider index managed funds?
The indexing pioneers
Introduction
Since the first Australian managed fund was launched in 1936, they have become a popular form of investment in Australia. Now, millions of Australians invest over $1.2 trillion in managed funds. So why are managed funds so popular, and more importantly, how do they work?
Managed funds provide a cost-effective way for investors, large and small, to access a diversified mix of investments in a professionally managed package. Because your money is pooled with other investors you can invest in assets which might be too difficult or expensive to invest in directly yourself.
This Plain Talk® guide introduces the concept of managed funds: describing the types of funds available, how they are managed and their benefits and costs. It aims to improve your knowledge and understanding of managed funds and help you make more informed investment choices.
What is a managed fund and how does it work?
A managed fund pools together people's money to invest in a range of investments.
Typically, a professional fund manager makes investments on behalf of the pool of investors in line with the fund's stated investment strategy and objectives. Instead of owning the investments yourself, like when you buy shares directly, the managed fund owns the underlying investments on your behalf.
Most managed funds are divided into units - so when you invest in a managed fund you are usually purchasing units in that fund. The number of units you are allocated will depend on how much money you have invested and represent your share of the fund.
While the number of units you own doesn't change, their value will change in line with the market value of the underlying investments. This is measured by the unit price.
There are many different kinds of managed funds offering a range of investment objectives and strategies. Managed funds generally have a Product Disclosure Statement (PDS), which clearly states the investment objective, benefits and costs of the fund.
The PDS also details the types of investments the fund will hold, how the investments will be managed and the types of risk investors can expect.
Why invest in managed funds?
Professional management
Your investment is managed by professional fund managers who are paid to monitor and manage the assets of the fund. These investment experts combine market and corporate knowledge to keep abreast of the markets and companies in which they invest. Fund managers are responsible for investing unitholders' assets in accordance with the fund's investment objectives.
| Smart investing tip 1 - invest often Timing the markets for the best time to invest is easier said than done, which is why many investors use a dollar cost averaging strategy. With this strategy, you invest a set amount into a managed fund on a regular basis, regardless of the unit price, to average out market fluctuations over time. |
Diversification
As your money is pooled with other investors, you can access a much wider range of investments than you can by investing directly yourself. It would be very costly and difficult to build the same level of diversification as an individual investor. Because managed fund investors enjoy a greater level of diversification than direct investors, they are less exposed to the performance fluctuations of individual shares or securities. An Australian equity fund, for example, might have 100 or more shares in its portfolio. This compares to an average of nine shares held in a direct investor's portfolio.*
* ASX, 2006 Australian Share Ownership Study
Access global investment opportunities
As an individual investor it is difficult to build up a portfolio of international investments directly. Investing internationally can increase your diversification further and give access to industries and companies not available in Australia. After all, Australia represents less than two per cent of the total world sharemarket.
Long-term growth potential
Managed funds provide the opportunity to grow your money over the long term.
Investing in growth assets such as shares and property can help protect the purchasing power of your money over time. The powerful combination of compound returns and time can make a big difference to the value of your investment. It is important to remember that past performance is no guarantee of future performance, and that returns can go up as well as down.
Income
Managed funds can provide a regular source of income. Some funds offer monthly, quarterly or six-monthly income distributions to investors. Investors can choose to take distributions in cash payments or reinvest the money back into the fund. Reinvesting the income you receive on your investments back into the fund can have a compounding effect. This means every dollar you earn on your investment is reinvested, giving you the potential to earn higher returns.
It's simple
Investing in managed funds is easy. Essentially the only decisions you need to make are deciding on the fund manager and fund type that suit your investment style and objectives.
The fund manager takes care of managing your money on your behalf. This means you don't have to worry about trying to time markets and choosing which companies or securities in which to invest.
You do not need much money to get started
Managed funds are suitable for a wide range of investors: from first-time investors starting out with a small amount, individuals with millions of dollars to major institutions, like superannuation funds.
Flexibility
Most fund managers offer a switching service, which allows you to change funds quickly and easily if your investment needs or circumstances change. You should check the PDS for information about switching, including any costs involved.
Types of managed funds
Managed funds offer a wide choice of investment options. For example, you can choose from single sector funds like Australian share and international share funds, or diversified or multi-sector funds that include a mix of sectors like shares, fixed interest and property. The mix of assets in a diversified fund reflects the risk profile of the fund - usually described as conservative, balanced or growth.
Investments are divided into growth or income assets. Shares and property are growth assets that primarily provide returns in the form of capital growth. Over the longer term these assets can provide a good hedge against inflation.
Bonds and cash are income assets that primarily provide returns in the form of income. Income assets tend to provide more stable, albeit lower returns.
The right type of investment for you will depend on your investment objectives, timeframe and tolerance for risk. The following are the most common types of managed funds.*
*This is general financial product advice only. We have not taken your circumstances into account when preparing this publication so the above information may not suit your needs. You should consider your circumstances and consult your financial adviser before making any investment decision.
Single sector managed funds
Cash
- for short-term investors;
- usually includes higher interest paying securities than bank accounts or term deposits; and
- lowest risk of all asset classes.
- for short to medium-term investors (around three to five years);
- low to medium risk;
- can provide a steady and reliable income stream and potential for capital growth;
- usually offer a higher interest rate, or yield, than cash; and
- access Commonwealth Government, state governments, semi-government authorities and company debt from Australia or overseas.
- for medium to long-term investors (five years plus);
- lower risk growth asset than shares;
- returns include income and capital growth;
- diversification benefits with access to properties in retail, office, industrial, tourism and infrastructure sectors; and
- you can invest in both Australian and international property security funds.
- for long-term investors (seven years plus)
- potential for higher returns with higher risk;
- potential for income through payment of dividends and tax benefits in the form of dividend imputation; and
- access a diversified range of companies listed on the Australian Stock Exchange
- for long-term investors (seven years plus);
- potential for higher returns with higher risk;
- access industries and investment opportunities not available in Australia; and
- diversification benefits when investing in a range of countries, industries and companies.
- available in a mix of investment profiles from conservative to more aggressive;
- investment timeframe depends on type of fund chosen;
- invests in more than one asset sector;
- diversified approach can lower risk; and
- professional fund manager decides the asset allocation (i.e. how much to invest in each asset sector) of the fund according to the fund's investment objectives and prevailing market conditions.
Risk and return
The overall performance of a managed fund simply reflects how the underlying assets are performing. The market prices of these assets can go up and down daily.
As performance can be volatile in the short term it is best to take a longer-term perspective (five years plus) when assessing managed funds.
It is also important to remember that past fund performance is no guarantee of future performance.
| Smart investing tip 2 - invest long term People often get caught up with short-term stock selection, which can deliver inconsistent results. While one stock might deliver great returns one year, it is difficult to pick winning stocks every year. When it comes to investing, it generally pays to invest for the long term. |
The graph below illustrates how, over time, the ups and downs of investment markets tend to even out and the gap between the highest and lowest returns closes. This is why it is important to consider your investment timeframe when choosing a managed fund.
While growth assets, like shares and property securities, tend to have more volatile returns over the shorter term - meaning they are likely to produce negative returns more often than income type investments - they have the potential to produce higher returns over longer-term timeframes.
Generally, the longer your investment timeframe the higher the level of growth assets you can include in your portfolio. The graph below shows the highest and lowest returns achieved by each asset class over one, five and 10 year periods to 30 June 2007.
| Smart investing tip 3 - diversify One of the most important decisions investors make is how they divide their investment between each asset sector, referred to as asset allocation. Diversifying across a range of asset sectors, industries and securities reduces market risk and can improve your performance potential. In multi-sector managed funds the fund manager does this for you. Smart investing tip 4 - costs matter Costs can take a large chunk out of an investor's return. So, it's important to compare fund fees before you invest. Look at things like contribution fees, adviser commissions and management fees as these can all add up over time. |
Diversification and risk
Spreading your money across a range of investments is one of the best ways to reduce your exposure to market risk. This way you are not relying on the returns of a single investment. Investment markets move up and down at different times. With a diversified portfolio of investments, returns from better performing investments can help offset those that underperform.
You can achieve diversification through a managed fund in a number of ways:
- invest in a fund that has exposure to different asset sectors, such as shares, fixed interest and property;
- invest in a fund that holds a spread of investments within an asset sector, such as different countries, industries and companies; and
- invest in a number of managed funds managed by different fund managers. For example, blending active funds with index funds - this is covered in the 'types of fund managers' section.
Managed fund costs
Like any other investment, there are fees involved in putting your money in a managed fund. The types of fees charged will vary from fund to fund and will depend on the type of investment. All managed fund fees must be disclosed in the fund's PDS.
The managed funds industry is regulated by the Australian Securities and Investments Commission (ASIC). Under the Corporations Act, all managed funds must disclose their fees and charges in a standardised format. Where possible, fund managers must give investors examples of the fees charged in dollar terms. This helps investors compare the fees across different funds.
The types of fees you may pay when investing in managed funds are outlined opposite. Not all funds charge all of these fees, so check the PDS for information on fees before you invest.
Entry or establishment fees
Some funds charge a fee to open your account for you. This can be up to five per cent of your initial investment.
Contribution fee
This fee may apply every time you make a subsequent investment.
Withdrawal fee
A fee may be charged every time you make a withdrawal from the fund.
Exit or termination fees
Some funds charge a fee when you close your account. This fee may apply if you close your account within a specific timeframe.
Management costs
This fee is charged by all funds and covers the administration costs of running a fund, such as accounting, legal and audit fees, fund documentation and investment costs. It excludes transaction costs, which are covered in the buy/sell spread.
Switching fee
Some fund managers may charge a switching fee when you switch between funds or investment options they offer.
Buy/sell spread
The buy/sell spread is simply a reasonable estimate of the transaction costs that a fund will incur when buying and selling assets to invest application monies and to meet withdrawals. These transaction costs may include brokerage, custody costs, government taxes and bank charges. The purpose of the buy/sell spread is to protect investors in the fund when other investors move money in and out of the fund.
Adviser service fee or trailing commission
This is the fee you may be charged by your adviser for advice about your investments in the fund. An adviser may also receive other amounts as commission. Not all funds pay adviser services fees or commissions.
Master trusts and platforms
You can buy managed funds directly from some fund managers, like Vanguard for example, but often investors access them through an adviser using a master trust or wrap account platform. These administrative platforms incur extra fees, which must be disclosed in the disclosure documents for the master trust or platform.
Comparison of retail management costs
Lower costs can translate into better performance for investors over the long term. One of the major advantages of using an index fund is the lower costs. In fact, Vanguard's retail fund costs are around half the industry median.
How fees can reduce returns
As the following example shows, fees can accumulate over time and impact your final investment results. The table below shows how managed cost differences between funds can affect your total return over time. This example assumes an average return for the periods stated for a $20,000 investment. Fund A has a higher management cost than Fund B.
How are managed fund returns determined?
The returns from a managed fund can be broken down into two components - the fund income return and the fund's growth return. The income return is based on the earnings of the fund's assets over a period of time and may include income from share dividends, rent from property and interest income. It may also include any capital gains generated from assets being sold. The income generated is paid at regular intervals to the investor in the form of distributions, which can be either paid to the investor in cash or reinvested back into the fund.
The growth return represents the increase in the value of the assets held by the fund and is reflected in the unit price of the fund.
Tax: the hidden cost*
*Vanguard does not give or purport to give tax advice. You should seek professional advice relating to your own particular circumstances as taxation laws are very complex and subject to constant and rapid change.
Distributions paid to you from a managed fund throughout the year are assessed as part of your taxable income just like other income you receive, such as rent, wages and bank interest. Some asset sectors, like shares, provide tax concessions through dividend imputation. Because companies listed on the Australian Stock Exchange have already paid tax on the profits they distribute, investors receive a franking credit for the amount of tax the company has paid.
Investors can use franking credits as an offset against their income tax liability. For example, a person on the top marginal tax rate
who receives a fully franked dividend would receive a tax credit of 15 per cent on their distribution. This represents the difference between the highest marginal tax rate of 45 per cent and the company tax rate of 30 per cent as at 1 July 2007. For investors on a marginal tax rate of 30 per cent, their distribution would be free of further tax.
Like direct share investors, unitholders in managed funds may also have to pay capital gains tax. Capital gains are generally only taxable once realised, that is, when the asset is sold for a profit. For investments held for more than a year, certain discounts may apply to the amount of the capital gain that is taxable, for example for an individual investor only half of the capital gain will be taxable, while for a superannuation fund investor, only two thirds of the capital gain will be taxable. For short-term capital gains (on assets held for less than 12 months), the entire capital gain will be taxable. Similarly, if you redeem some or all of your units in a managed fund and you have made a profit - you may have to pay capital gains tax on that profit, and the discounts as described above may also apply.
| Smart investing tip 5 - less tax can mean higher returns What's left in your pocket after tax is what really counts. Actively managed funds usually trade more often, which means they may generate more capital gains tax liabilities that can reduce returns. Index funds trade less, so they realise capital gains less often. |
Some investment styles are more tax-effective than others
A fund manager's investment approach can make a big difference to the amount of tax you pay on your investmentearnings and the amount of investment return you get to keep.
Turnover is one of the most important indicators of the tax efficiency of a managed fund. Turnover of a fund manager's assets reflects the level of trading activity within a fund and is usually much higher in active funds. Some fund managers can turnover their portfolios by 100 per cent or more in a year. Fund managers that regularly turnover their investment portfolios will attract much higher realised capital gains than those that use a 'buy-and-hold' approach.
Vanguard's 'buy-and-hold' strategy minimises turnover so our funds can take advantage of capital gains discounts. Minimise Tax, Maximise your Clients' Portfolios, Navigator Research (2006) ranked Vanguard's Australian Share Index Fund in their top five Australian equity fundsfor tax effectiveness. With fund turnover of only two per cent, Vanguard's fund had the lowest turnover of all funds in the sample.
Types of fund managers
A management style is a framework that guides the way fund managers evaluate and select the investments they make. It is like a set of principles based on the fund manager's beliefs about investment markets.
When choosing a fund manager, it is important that you feel comfortable with their investment style. Because different investment styles will perform better at different times, some investors choose a number of different fund managers to manage their investments.
Active and index fund managers
Index managers aim to match the performance of a market index by investing in all or a representative sample of the securities in the index.
A benchmark index measures the performance of a basket of securities. For example, the S&P/ASX 300 Index measures the performance of about 300 companies listed on the Australian Stock Exchange. Because index funds usually invest in all or most of the securities in the index, they provide diversification which means lower risk.
Active fund managers will usually try to outperform the market index by choosing a selection of stocks they believe will outperform the benchmark index. Active fund managers will hold a much smaller portfolio of stocks than index managers and they tend to charge higher fees as they have higher costs in the form of research analysts as well as transaction costs from trading securities much more often.
There are several different active investment styles but the three most common are 'growth', 'value' and 'style-neutral' (also known as core). For example, growth managers favour companies that have a solid earnings growth outlook. Value managers will look for market inefficiencies in the market and seek stocks they believe are undervalued in the market.
Why consider index managed funds?
Since first being introduced in the United States in the early 1970s,indexing has become an important way of investing for institutional and individual investors around the world. In Australia, index funds now total around $141 billion.*
* Rainmaker Roundup December 2006
Index funds offer competitive long-term performance*, are broadly diversified and have low costs. The philosophy behind indexing is that markets generate returns - not fund managers. By adopting a 'buy-andhold' approach, the cost of investing can be significantly reduced over time and this can lead to better returns for investors in the long term,especially on an after tax basis. This is because funds that 'buy-andhold' securities are more likely to qualify for capital gains discounts and deferral of capital gains liabilities, than funds that trade more often.
* Past performance in not a reliable indicator of future performance
Index funds usually invest in all or most of the securities in an index and they provide additional diversification to investors, which lowers risk.
Unlike most active fund managers, index managers do not try to beatthe index - they aim to capture the market return. Few active fund managers can sustain above benchmark returns after costs over the long term. This has meant that index funds returns are competitive with active fund returns over the long term.
The graph below shows themedian return for managers inthe Mercer Retail Investment Surveys against the relevantindex in each asset class over the last five years.
As index fund managers don't employ huge investment teams to research investment markets and companies, index funds can charge much lower management fees than active funds. Vanguard's fees range from between 0.7 per cent and 0.9 per cent per annum, which is well below the industry average, according to Standard & Poor's.* Vanguard does not have entry or exit fees, contribution or switching fees (apart from the usual buy/sell spreads that apply to all transactions) and does not pay commissions to advisers.
5 Standard & Poor's Research as at February 2006
*Vanguard offers scaled fees, so investors pay a lower fee on amounts over $50,000. Index funds are also easy to understand.
They are all about recognising the simple principle that investing isn't about picking short-term winners, but about accumulating wealth over the long term. The world's best-known share investor manager, Warren Buffett, acknowledged this in his 1996 letter to Berkshire Hathaway shareholders:
"Most investors, institutional and individual, will find the best way to own common stocks (shares) is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) of the great majority of investment professionals."
The indexing pioneers
Vanguard pioneered the concept of indexing, introducing the first retail fund in the US in 1976. Vanguard has since become one of the world's most experienced and successful indexing specialists. In fact, the Vanguard Group manages more than $1.4 trillion worldwide.
Vanguard recently celebrated 10 years in Australia, managing more than $65 billion on behalf of Australian and international clients as at 30 June 2007.
Vanguard® index funds
Personal and professional investors alike can benefit from Vanguard's high quality, low-cost investment solutions.
Vanguard's unique indexing approach is a proven long-term strategy for wealth, super and Self Managed Super Fund (SMSF) investors.
Our funds are available direct through us or on a wide range of platforms through financial advisers and include:
- Index funds: a range of single sector and diversified options suitable for individuals, joint investors, SMSF investors, businesses and trusts. Low fees, no upfront fees (normal buy/sell spreads apply) and scaled management costs are just some of the benefits; and
- Personal super: flexible super plan you can use throughout your working life with low fees, choice of investment options, easy switching facilities and more.
