Heading in the right direction

The advantages for advisers, and clients, of using direct investing over managed funds appear to be many and varied, but perhaps none of these are as compelling as the simple motivation Leonie Henry offers for using them.

Director of Brisbane-based Leonie Henry Financial Planning, Henry says the key advantage for her is that she can “sleep at night”, largely because direct investment does not produce “too many surprises in our client portfolios”.

As well as giving her “better control over our clients’ money, direct investing allows her to know “how much we are going to be paid each year, as we are not reliant on the vagaries of the market as to how much we get paid”.

She is paid an “amount of money per quarter by each client, based on what work we expect to do over the next 12 months, which effectively enables me to predict within $20,000 how much I am going to earn in a year’s time, and we turn over about $900,000 a year”.

“I assume any practice that uses managed funds for investors is usually paid by trailling commissions, which, by contrast, would make them reliant on the vagaries of the market as to how much they get paid.”

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Like other interviewees for this report, Henry believes more advisers are going into direct investing, which she started out on 15 years ago, although she doesn’t believe it’s a “large representative proportion” of planner numbers.

“In some ways it’s harder to get into direct investing as a strategy,” she says, with a key barrier to entry being that it “takes longer to develop income from using this strategy. If you put into managed investments you start getting paid for it straight away, whereas with direct investing you have to wait to get paid.”

She uses the direct investment approach as a way of “bringing efficiencies into her practice by having all of our clients using a similar direct approach [of buying stock through listed investment companies]”.

“We don’t typically offer the use of managed funds as an alternative.”

Neither does she usually offer clients use of a platform, although there are “two or three” of a total of 110 clients who do use these.

“Sure, they are efficient from a back-office perspective, but the price the [average] client has to pay is “just too high to justify their use”.

She also does not offer clients individually managed accounts (IMA) or self-managed accounts (SMA), readily acknowledging that she does not understand these, a viewpoint she is surely not alone within industry in holding.

However, she does employ an inhouse salaried stockbroker, which allows her to compensate to some extent for the “lack of control we have in terms of pricing” for the stock bought on behalf of clients.

The in-house broker has developed a research system that allows him to work out what is a reasonable entry price for each stock, she says.

“We won’t buy it unless and until it falls into our entry range. This allows us to be reasonably confident that we can purchase stock very well for our clients, although some times we will wait up to six months to buy a stock at good value. Again, it helps that we are not dependent on the money from a sale for our income.”

Henry’s approach to clients is “on the basis of a partnership”, and she also “employs a very specific discipline on how their portfolio is going to be constructed and managed. Everything that happens in a portfolio is something we discuss with them, and which they authorise us to do.”

She also operates on the basis that direct investing “provides the transparency of portfolio I don’t believe you can get in managed funds”, something she tells each new client from the outset.

“We run each client’s account entirely through a separate bank account, which acts in effect like a physical wrap. Everything that happens with their portfolio goes through that bank account, allowing us to see all transactions and income and expenses,” she says.

The direct strategy is also aimed at “providing a reliable income for clients”, which, again, she believes are not available from managed funds.

“The essence of our operation is to find out from clients what is needed on your portfolio in terms of income, against a benchmark which is normally set at around about 5 per cent plus CPI.

“We then look at what it is we need to purchase that is going to be able to deliver on that and what is a reasonable growth factor we can expect from those over time, growth over and above income,” she says.

Centric Wealth head of equity research Paul Zwi believes direct and managed fund investment strategies “perform slightly different functions for different clients and have different attributes, and therefore both have a place in a client portfolio”.

“Most of our clients would hold managed funds, in fact. Even those very keen on direct investing would still have managed funds to gain access to global equities, or small cap funds and those who want diversification.

“They might invest directly so as to gain core exposure to Australian equities but could still use managed funds to access global or small cap funds, or in fact for a global resources exposure.

However, Zwi says there is “advantage and appeal in having direct shareholdings, in that there are central attributes to the strategy which you don’t get with managed funds”.

“The ability to customise the portfolio is one of the attributes,” he says.

“If you had exposure only to a managed fund it would be very difficult if not impossible to customise a portfolio.

“For example, some of our clients are senior executives at one of the large banks, and they would have large holdings either in options or shares in the bank. They may not therefore want exposure to other banking stocks in their portfolio, or even for ethical concerns.

“Probably the key attribute that comes into play with direct holdings is the management of tax, harvesting tax losses, and offsetting gains with losses,” he says.

“If you’re in a managed fund, that’s very difficult to do, but not when you have, say, a portfolio of 15 directly held shares. Then it becomes part of your value-adding proposition that if you have realised a capital gain during the year, you can look for an offsetting loss and neutralise that tax liability.”

On the issue of fees, he says, if you buy a managed fund you are paying someone for their portfolio management expertise.

“But do you really want to pay an annual management fee, whether it’s 1 per cent or 1.5 per cent, if you are going to be a long-term holder in what you might regard as core stocks.”

Toby Potter, director of administrator Model Portfolios, said SMAs offer more of a turn-key solution for a planner who does not have direct portfolio management skills in addition to their planning skills.

Depending on a client’s required level of participation, SMAs can be structured to be totally responsive to a client’s direct investing needs, and that’s the key to its value add.

“It could even replicate the portfolio offered within a managed fund structure, in which case you would get the best of both worlds — the stock picking skills of a highly regarded fund manager, but with the added benefits of direct shares, such as tax management.

Potter says SMAs also make it possible for dealer groups to “take control of their product service delivery, rather than simply becoming platform or managed fund sales organisations”.

“The benefits lie not only in the ability to control pricing, but also, and more importantly, to offer a differentiated service to clients that cuts across all product classes, direct securities, managed funds, bonds and so on.”

There are quite a lot of important benefits for clients that come from improved control of securities, and more precise alignments of the client’s objectives, better control of tax reporting, and more transparency around fees and holdings.

Potter says he was “focused on promoting” SMAs as an opportunity to enhance the profitability of dealer groups, suggesting SMAs can typically enable the dealer to double their revenue.

He says there are two alternative courses of action open to dealer groups considering direct investments at present, both of which leads to pretty specific administration and compliance problems.

“They either use direct securities, predominantly through a client specific holder identification number (HIB), where they end up in this high administration high-compliance environment.

“Alternatively, they use managed funds, in which case they end up in a low-admin, easier-compliance regime, but with an altogether less satisfactory service offering for the client.”

SMAs are “not necessarily” a high-net-worth product, and are in fact becoming a middle market product, with the growth area for SMAs in Australia the result of the very high penetration of share ownership among households.

“There are a very significant number of investors out there who have $100,000 to invest, who are familiar with the positives and negatives of direct equity ownership, and who nonetheless value personal advice from an adviser and who value professional investment management.”

He estimates the administration and investment management costs of SMAs as “no more than the cost of a wholesale unit trust, which means the platform and administration costs are then no longer required”.

Boutique fund manager Hyperion Asset Management managing director Manny Pohl says the attraction of SMAs lie in offering generally high-net-worth clients an alternative method of direct investing.

“They don’t need to be involved in the issues they’re not equipped for, such as management of corporate actions and the investment trading decisions.”

Pohl says another key attraction is in providing clients with “access to boutique managers, who could manage their accounts irrelevant to the benchmarks” that often dictate the investment activities of larger fund managers”.

The nature of unit trusts is that they perform similarly to the benchmark, meaning there will either be some value created or not around that benchmark.

“Managed funds are therefore predominantly run by large managers who are more concerned about the business risk than the returns to their client.

“They can’t have a portfolio that doesn’t have News Corp or BHP in it, and at between 8 and 12 per cent, because the index is about 9 per cent.”

However, if you invest through an IMA you get a manager who is focused on producing the dollar for you, rather than on the business risk to them.