This article appeared in the April 2012 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.
Learn about the features, benefits and risks of this investment product.
By Jemima Joseph, Morningstar
Investing directly in shares is a common investment approach for many people. An alternative is to invest in a managed fund.
"Convenience, diversification and professional management." We have all heard these alluring buzzwords used in television advertisements of investment managers trying to entice us to their latest managed fund offering.
But before taking the plunge into a managed fund, ensure you completely understand the mechanics of this investment vehicle. Let us start with the basics.
(Editor's Note: ASX is working towards quoting active managed funds on ASX this year. More information on this important initiative is available. ASX will run investor events on this service later in 2012. If you would like to be informed of ASX events about managed funds as they are confirmed, reply with your email address).
Investments in many asset classes
A managed fund is a professionally managed investment vehicle that collects money from several investors to form an aggregated pool of funds. (Editor's note: this story refers to unlisted managed funds. Information on listed managed funds is available here)
Using a predetermined investment mandate - being the set of rules that govern the investment strategy - expert investment managers invest this pool of funds across various asset classes, such as equities, fixed interest and cash.
From the perspective of the individual investor, this is a significant benefit of such an offering, as it gives exposure to asset classes that traditionally would only be available to institutional investors.
Most managed funds adopt a unit trust structure, meaning that when you invest your money is moved into the fund and units are created and issued in return. The fund continues to issue new units to new and existing investors from the fund's inception date until it is closed to new and existing investors, if applicable.
Unit price reflects fund's value
The value of each unit is referred to as the unit price and therefore the number of units an investor receives when buying into a fund depends on the amount invested and the unit price on the day. For example, if the unit price is $1 and you invest $1000, you receive 1000 units.
The unit price is a reflection of the value of the fund, that is, the value of the pooled investment. If the value of the fund increases, the unit price will rise. Conversely, if the value of the fund decreases, the unit price will decline.
Many fund managers display the current unit prices of their funds on their websites. If the fund is open to investors, there will be two unit prices: an entry price and an exit price. If a fund is closed to new investors, only an exit unit price is given.
Morningstar collects this information across the entire managed funds industry and it is available on its website, as are various other Morningstar products and publications.
If you want to sell out of a managed fund you simply sell your units back to the fund manager and receive the market value of your units - the exit price at the date of withdrawal.
Direct and indirect costs
Fees can significantly affect the value and success of investments and are an important topic to examine.
The Australian managed funds industry is regulated by the Federal Government body, ASIC. As detailed in the Corporations Act, all managed funds are required by law to outline all fees in product disclosure statements (PDS). This is an excellent starting point in understanding what fees and charges you can expect to pay.
Each offering has a different type of fee and the amount can vary widely depending on investment strategy, the amount invested and, in some cases, the duration of the investment. Here are some fee considerations:
From the outset, it is important to make the distinction between direct and indirect costs. Direct costs are the fees charged directly to the investor's account when a transaction occurs. Typical examples are:
- Entry/establishment fee: Charged for opening an account with the fund manager. It varies from fund to fund and at times may be waived
- Contribution fee: Charged on your initial investment into the fund and any subsequent investments/contributions
- Withdrawal fee: Charged every time you make withdrawals. Also known as a redemption fee
- Exit/termination fee: Charged any time you want to leave the fund (that is, close your investment)
- Switching fee: Charged for switching between a fund manager's series of funds or investment options (such as from "balanced" option to "growth" option)
- Adviser service fee: If you use an adviser in selecting a managed fund, the adviser may charge a fee. With the Future of Financial Advice (FoFA) reforms coming into operation soon, this fee will become more common.
Annual management fee
That seems a long, exhaustive list, but this is only one dimension to the fees story. When indirect costs come into the picture, the most well-known is an annual management fee.
This is usually expressed as a percentage of funds under management and quoted on a per annum basis. For most funds, this fee is charged on a daily basis but at a fund level as opposed to an investor level, and this is what makes it an indirect cost.
However, management fees in isolation do not provide a complete representation of the total indirect cost involved in investing in a managed fund. This is why fund managers provide investors with an annual indirect cost ratio (ICR).
ICRs measure the total indirect costs of managing a fund. These are the costs that are not deducted directly from an investor's account.
Such costs include management and performance fees, investment-related legal, accounting and auditing, and other operational and compliance costs. The aggregation of these indirect costs are divided by the average net asset (the size) of the fund and presented as a percentage.
A fund's ICR is the same for all who have invested in that fund. Therefore, regardless of the amount invested, the total indirect cost as a percentage of the amount invested is virtually the same. The exception would be in a tiered fee structure, where management fees vary depending on the amount invested.
As mentioned, when an investor buys into the fund the fund manager uses the money to invest in the capital markets and develop the fund's asset size.
Conversely, when an investor exits the fund, the manager may need to trade the fund's assets to meet the withdrawal. This activity involves transaction costs such as brokerage fees and bank fees, all of which are paid by the fund. These costs are reflected in a buy/sell spread.
The buy/sell spread is merely the difference between the unit entry price (buy price) and exit price (sell price) of the fund. It is expressed as a percentage of the fund's net asset value (size).
It is important to note that these costs are retained by the fund (that is, investors are not charged a buy/sell spread). This spread ensures that new investors joining the fund or existing investors leaving contribute towards these transaction costs.
It also ensures that those who stay invested in the fund do not bear the financial cost of these transactions.
Fee analysis is only one aspect of understanding a managed fund. It is imperative that you know the types of managed funds available and how fund managers are investing your money. (Editor's note: unlisted managed funds sometimes create unexpected tax outcomes when investors sell their units and leave the fund).
About the author
Jemima Joseph is a Morningstar analyst.
ASX's initiative to quote managed fund prices will make it easier for investors to apply for and redeem units in managed funds, provide more certainty around managed fund entry and exit prices, and improve asset allocation options for investors under a process similar to how ASX-listed securities are currently bought and sold. This story provides more information on the change.
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