This article appeared in the July 2010 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
By Kris Vogelsong, Private Portfolio Managers
Investment structures can play as big a role in determining real returns as asset allocation or investment strategy, yet many investors simply overlook them. The recent popularity of structures such as exchange traded funds (ETFs) and managed accounts has highlighted the effect investment structures have on returns.
Australian investors can now choose from managed funds, listed investment companies (LICs), ETFs, structured products, and managed accounts - each with very different taxation outcomes, portfolio management implications, and costs.
Tax is especially important when evaluating investment structures. Tax treatment and efficiency can differ substantially between structures, and with the highest marginal tax rate of 46.5 per cent, tax is likely to be one, if not the largest, factor in an investor's real returns.
To make a good choice you need to understand your objectives and circumstances, and consider the fit against the characteristics of the different investment structures.
There is now more than $1 trillion held in managed funds, representing the simple proposition of pooling together money from many investors to purchase a portfolio of assets managed by a professional fund manager.
Although the popularity of managed funds is undeniable and the choice of investment exposures extensive, they can create problems for investors from a taxation perspective. To accommodate the continuous flow of money into and out of the fund, the manager must regularly rebalance the portfolio, and that trading activity creates tax consequences for all investors in the fund, not just those coming or leaving.
Investors in managed funds inherit an existing tax position depending on how well or poorly the fund has performed in the past; you may end up paying tax on returns the fund earned before you invested. In the United States, these embedded tax positions are disclosed but Australian funds do not make them public, so investors cannot be sure what tax position they may be inheriting.
Listed investment companies (LICs)
LICs share some similarities to managed funds in that they pool investors together to invest in a portfolio of assets. However, LICs have some significant differences and should not be considered listed surrogates for managed funds.
These differences include a fixed capital structure where the distractions of fund inflows and outflows are absent. Instead, investors buy and sell from each other at market prices, just like any other share. This means the market price can be above or below the value of the portfolio they hold, creating both a risk and an opportunity because investors' returns will be based on both the performance of the underlying assets and the market's view of the company.
LICs also have an embedded tax position but, unlike managed funds, these are disclosed on a monthly basis. The ASX website has a summary table of LICs. For many investors, part of the appeal of LICs is the ability to 'even out' returns through good periods and bad, providing a consistent stream of franked dividends. It is worth noting that many LICs achieved this outcome through the global financial crisis. Also worth noting is that these dividends can be both fully franked and carry a capital gains tax concession - an attribute no other structure can provide.
Exchange traded funds (ETFs)
ETFs have attracted a lot of attention with their simple 'no surprises' proposition. Most of the growing number of ETFs target a passive low-cost index exposure to Australian or overseas equities.
Many commentators see ETFs capturing investments that would have traditionally flown into managed funds. This could be particularily true in the case of international equities, where the investment proposition is more about asset allocation than share selection. International ETFs also have a significant advantage over international managed funds - international ETFs generally do not make annual tax distributions, managed funds do. The net effect is international ETFs can provide a tax-deferral benefit that managed funds cannot match.
There is a wide range of structured products, each designed to provide a specific investment exposure and/or tax outcome. They come in many different configurations and it is difficult to characterise them generally. It is important to research and fully understand individual products.
Separately managed accounts (SMAs)
SMAs are a relative newcomer in Australia and provide investors with a portfolio of shares held directly in the investor's name but managed by a fund manager. Holding shares directly has a number of benefits, including avoiding the imbedded tax positions common in other structures, and transparency of both holdings and transactions.
Investors putting money into an SMA will own the shares contained in a model portfolio assembled by the fund manager. Each account will hold the same shares and in the same proportions as the model portfolio, with any change in the model reflected in all the corresponding accounts.
It is possible to import an existing share portfolio into an SMA without liquidating those positions (and paying any associated tax) but only to the extent and proportions your shares are contained in the SMA model portfolio.
Individually managed accounts (IMAs)
IMAs share some of the same benefits as SMAs, although there are important differences in how they operate. Both structures provide a portfolio of directly held shares and the tax benefits associated with direct holdings. Unlike the model portfolio basis of SMAs, investors using an IMA receive a portfolio managed specifically to meet their objectives and tax circumstances. Therefore each investor receives a somewhat different portfolio based on the available opportunities at the time of investing, the composition of any shares they transfer into the IMA, and a range of individual tax considerations. An IMA is akin to having your own personal fund manager.
Another important difference with IMAs is that they are considered a service rather than a product, so the investment management fees can be tax deductible. However, you will generally need a large amount of cash and/or existing shares (anywhere from $500,000 to $5 million) to enlist the services of an IMA manager.
Choosing the best structure
There is no single right structure for every investor. Private Portfolio Managers (PPM) have recently prepared a paper entitled Investments Structures Matter (PDF 260KB) outlining the benefits and drawbacks of each structure.
When assessing the best structure for your circumstances, ask yourself these five basic questions:
- What are the objectives for the investment and how will the structure either support or conflict with those?
- What is the tax position under which I am investing (high marginal rate, SMSF, etc) and will the structure provide a good tax outcome given my tax position?
- What costs are associated with the structure? Consider not just the management expenses but any switching, transaction or entry costs, capital gains tax realisations and ongoing taxation.
- Does the structure support or constrain the investment manager's ability to produce returns? Consider after-tax returns rather than headline returns.
- If the investment proves unsatisfactory, how easy and at what cost can I exit? Consider the investment's liquidity, applicable exit fees, and tax implications.
Most importantly, and like all other areas of investment, a solid understanding of investment structures goes a long way toward success.
About the author
Kris Vogelsong is head of corporate development, Private Portfolio Managers, a leading boutique investment manager.
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