Managed funds vs ETFs - understanding the similarities and differences

Managed funds are supposedly a non-transparent and expensive way of investing, while ETFs are increasingly touted as low cost investment saviours.

Graham Hand outlines how similar the two investment products are when compared on a like-for-like basis and highlights the features that can set a managed fund apart.

Exchange Traded Funds and managed funds are very similar.

In fact, “ETFs are listed managed funds” according to the Australian Securities Exchange (ASX) ETF Fact Sheet. They are both open-ended funds which co-mingle assets and try to achieve a stated investment outcome.

Both investment options can be classified into two broad categories: index funds and actively managed funds. The former tracks the performance of an underlying index, while the latter aims to outperform a stated index through active management.

Although actively-managed ETFs are common overseas, they are not yet listed in Australia.

When comparing ETFs with managed funds, many financial commentators compare index ETFs to active managed funds, and claim significant cost savings for ETFs.

This is a misleading comparison, since most of the cost difference comes from active versus index management, not managed funds versus ETFs.

There is a legitimate debate worth having on the merits of passive versus active investing, but that is a separate discussion.

For an investor to make an informed decision, the comparison needs to be like for like – index ETFs versus index managed funds.

How do (index) ETFs and managed funds really compare?

The primary difference between the investments is the access mechanism. ETFs are by definition exchange-traded, which in Australia means they are traded on the ASX, whereas managed funds are usually accessed through a platform provider who offers index funds in its range of investment options.

An ETF’s price is confirmed at the point of execution on the ASX, while for an index managed fund, the cost is determined based on the Net Asset Value (NAV) price at the close of business on the day the investment is made.

ETF providers appoint market makers who endeavour to keep the bid/offer prices close to the NAV.

They do this by arbitraging (that is, making a profit on) any price discrepancy between the listed price and the NAV.

If an investor buys an ETF at a premium to its NAV, the investor faces an additional cost of investing in the ETF. Likewise, if an investor sells an ETF at a discount to its NAV, they also face an additional cost.

At the point of purchase, the investor does not know the NAV of the ETF, and their only guide is the movement of the corresponding index.

For a managed fund, while intra-day pricing is not offered, the investor can be sure the investment or redemption will be processed at the NAV less the spread.

Key differences between managed funds and ETFs

Other key differences between index ETFs and managed funds are the cost of access, the ongoing management cost, and the services each product provides to clients.

On the cost issue, an index ETF tends to be marginally (around 0.12 per cent per annum) cheaper than an equivalent index managed fund.

This difference is a payment for the additional services offered by managed fund providers, including consolidated investment and tax reporting, portfolio management tools such as auto-rebalancing and regular investment plans, access to a client services centre, and market newsletters.

In addition, the potential benefit gained by an ETF investor from the lower ongoing management fee can be outweighed by the brokerage costs paid to purchase and sell an ETF.

Brokers generally charge a minimum fixed dollar brokerage rate on trades of less than $10,000 – a figure which may represent a high proportion of the invested amount, particularly for those who make regular contributions.

For example, a brokerage charge of $29.95 on a $1,000 investment represents around a 3 per cent transaction cost, and although the brokerage rate falls for larger investments, a typical rate of at least 0.3 per cent applies for trades over $10,000.

To transact on an index managed fund, an investor will pay a spread of approximately 0.15 per cent.

Tax treatment can also differ. All of the ETFs listed on the ASX which provide exposure to non-Australian equities markets are US-domiciled.

Consequently, investors in these vehicles are subject to 30 per cent US withholding tax on their distributions.

This figure can be halved to 15 per cent if an investor completes and lodges a W8-BEN form with the US Internal Revenue Service and ensures this form is periodically updated to maintain the application of the lower tax rate.

While an equivalent managed fund is subject to the same requirement, the paperwork is handled by the fund, thus alleviating the investor of the administrative burden.

Other possible tax related burdens that can affect investors in US-domiciled ETFs include US estate tax, which comes into effect upon the death of the investor, and US generation-skipping transfer tax, which may come into play if the investment is transferred to a grandchild at death. These do not apply to index managed funds.

It is also important to note that if a superannuation investor wishes to invest in an ETF, it’s a requirement that superannuation is held in a trust structure which is compliant with the Superannuation Industry (Supervision) Act.

The only way an investor can do this without using a platform is by establishing a self-managed super fund (SMSF) or a small APRA fund.

There are a wide range of issues that must be addressed in determining whether an SMSF is appropriate for a particular investor.

These issues include administration requirements needed to maintain accounting and tax records, which increase the complexity and cost for the client, as well as a wide range of trustee responsibilities, which some investors may not be well equipped to handle.

Summary

Comparing index ETFs and index managed funds reveals a number of similarities, yet there are also some notable differences that need to be carefully considered prior to making an investment decision.

The investor and adviser should determine if they value the additional services offered by the managed fund provider and whether those services justify the minor difference in ongoing management costs.

They should also ensure they factor in the upfront brokerage costs – especially if they are dealing in small parcels.

Graham Hand is Colonial First State’s general manager of funding and alliances.