Benefits of managed funds warrant close analysis

With post-GFC investor confidence returning only slowly, a growing number of planners are placing their clients’ funds into direct shares. Paul Foster asks: is leaving only a fraction of inflows in traditional managed funds really the best investment decision for your clients?

In the wake of the global financial crisis (GFC), direct shares have become popular among investors, especially when the impact of the financial crash on managed funds is assessed.

However, it is now timely for planners and advisers to consider carefully why they would recommend direct shares as a primary investment vehicle for their clients.

If providing the highest returns for clients across the widest possible base is the key driver of an adviser’s business – and it should be – then the fact that managed funds have a long history of outperforming direct shares on the Australian market should be a consideration that is, in the current market, once again rising to top of mind. 

Of late, some financial industry commentators have adopted a view that they should not pay an active fund to achieve index-like returns, when managed funds don’t appear to add value beyond their fees.

However, there is a lot of evidence to the contrary. For example, in considering the S&P/ASX200 Accumulation Index, it becomes clear that managed funds have outperformed the market for at least the last 15 years.

There is an alternative way to look at the performance of managed funds, one which takes into account the following assumptions:

• Fund managers (including industry funds) hold 33.33 per cent, or one-third, of Australian shares;
• Fund manager fees are on average 1.0 per cent per annum; and
• The cost of brokerage, accounting and other fees of holding direct shares is 0.5 per cent per annum.

So, if managed funds have returned 0.78 per cent after fees, and fees are, on average, 1.0 per cent, then the return before fees for managed funds has been 1.78 per cent per annum better than the S&P/ASX200 Accumulation Index.

Over 10 years, this means that managed funds have averaged 10.08 per cent per annum before fees, while the ASX200 has returned 8.40 per cent.

If managed funds have held 33.33 per cent of all the Australian shares on issue, then the average return before costs and fees for those who hold direct shares must be 7.52 per cent.

Investing in shares isn’t free and assuming that this cost is 0.5 per cent p.a. on average, the after-costs return of direct shareholders is 7.02 per cent per annum over the last 10 years. 

So, the true comparison between managed funds and direct shares is that managed funds have outperformed direct shares by 2.01 per cent per annum over the last 10 years on an after-fees basis.

Investing in direct shares leaves the investor with a difference to make up before even reaching the mark of the average managed fund.

At KPMG during the mid-to-late 1990s, I reviewed the returns of clients with direct shares and managed funds. Over a six-to-12-month timeframe, a new portfolio of shares outperformed managed funds. However, when I reviewed the performance of these clients’ portfolios after 12 months, the managed funds were bridging the gap. 

For those clients who had held managed funds and direct shares for least three years, the managed fund returns were far superior. The reasons were simple:

• Managed funds were actively managed, whereas the direct shares were not;
• Clients and/or advisers fell in love with some shares in spite of poor performance or outlook, whereas the fund managers maintained their objectivity; and
• Clients and advisers didn’t like to sell a share that was underwater, whereas fund managers were prepared to take the pain for the overall benefit to the portfolio.

Comparing apples with apples

Another issue that has cast undeserved doubt on managed funds’ performance is the quality and relevance of the data used to assess overall managed funds’ returns. Market commentators often point to the “broader” and “long-term” data available out of the United States to demonstrate that active managers have underperformed the market. 

However, until very recently it was common practice among US fund managers to trade in their own managed funds after the market was closed each day, wiping a considerable amount of performance off the top, distorting performance figures and further impairing the credibility of the managed fund industry.

In Australia, however, this was not the practice and after-market trading in managed funds is in fact illegal (as it now is in the US, also).

The fact that these now obsolete figures are still used by some to draw conclusions about the locally managed funds industry is clearly wrong.

Reality vs perception: managed funds vs direct shares

Yet another significant issue for advisers to overcome is that some of their clients simply do not trust managed funds, particularly since the bad press during and after the GFC, when freezing of funds shook confidence and caused widespread financial pain.

Despite these negative perceptions, the benefits that contributed to the initial popularity of managed funds and their longstanding success in the market remain.

Many individual investors are tired of the vigilance and corporate interaction it requires to be direct shareholders.

From an adviser perspective, too, it is more efficient to service the greatest number of clients with managed funds rather than direct shares. 

Managed funds continue to offer investors access to scale, diversity and simplicity, providing clients with reduced investment risk and the potential for better returns.

Managed fund clients can benefit from the combined resources and knowledge of financial advisers and investment managers, the latter reviewing and assessing stocks on a daily basis. 

Alternatively, let’s look at the situation when it comes to direct share investment. A typical direct share investor might have holdings in 20 different companies.

This means that there are around 1,600 companies they don’t hold and aren’t watching day-to-day.

By contrast, managed funds are monitoring the stocks they don’t hold as much as the ones they do, albeit that they may also concentrate their holdings to as few as 20 stocks.

Clients often find the transparency of direct shares appealing – they like being able to view the whole portfolio. But advisers and planners can offer the same benefits with managed funds, by providing more regular updates of the fund’s progress and holdings through regular reporting.

In truth, often the decision between direct shares and managed funds can be determined by an adviser’s personal inclination: some like to be involved in the daily trade of shares and are ‘addicted’ to the cut and thrust of the market. 

Perhaps contentiously, it is my view that an adviser or planner with such a strong interest in shares should have a thorough and honest look at the results they have been achieving across their client base.

If they are consistently outperforming the sharemarket after fees, then they should apply for a job as a fund manager.

I believe it is more likely that if this is the case, they could well be spending so much time managing share portfolios that they may be underservicing in other vital areas.

Certainly, this possibility provides food for thought and self-reflection.

In summary, some advisers may feel they do not add value to their business if they don’t offer direct shares; as we have shown, higher returns can be had from managed funds – with far less time and effort spent, leaving advisers able to provide the real value-add: truly understanding their client and dispensing proactive strategic advice and coaching.

Paul Foster is CEO and CIO of Addwealth.