The Messenger: Does direct share investing measure up?

It is sometimes wrongly claimed that direct shares are more tax efficient than managed funds.

In assessing the significance of capital gain distributions from managed funds, the relative importance of maximising tax deferral versus maximising return needs to be considered.

Take Lend Lease as a classic example. Its share price rose strongly for many years but then collapsed and has not recovered. Had it been sold at its peak the largest amount of tax would have been paid, but the largest net worth retained.

Minimising tax can never be an absolute and must be weighed up against optimising exit price.

The objective presumably is to maximise net of capital gains tax (CGT) return. As a general rule, maximising gross return is the biggest single contributor to this.

Assume hypothetically that investors had a direct portfolio consisting of the same stockholding as a superior stock-picking manager (yes, these are rare), sayInvestors Mutual(IM), and mirror its purchase and sale decisions.

Investors would get the same gross return (ignoring fees) and would incur the same capital gains and income tax liabilities as from the fund. The dividends would have an identical degree of franking and the realised gain would have none.

Contrary to popular perception, there is no less franking from the fund. This misconception arises from the fact that the income and realised gain is paid as a single distribution. The fact that the gain component is not franked is unremarkable.

Neither is more tax efficient. The only way to produce a different tax outcome is to make different disposal decisions, that is, not to sell a stock when IM did.

An individually managed account does not alter this. If the direct shares are held in one’s own name or in such an account it presents the same portfolio disposal issues.

If IM’s decisions are generally sound, as its track record demonstrates, then failing to follow them is likely to produce a lower gross and net return over time, even allowing for tax deferral. There could be a small number of obvious exceptions, for example, it may make sense to defer the sale of a stock in the last week of June to the first week of the new financial year and hope that the price is maintained. The longer the delay, the more risk this entails.

A stock is sold for a reason, either because it becomes over-priced or a better opportunity is identified. The issue is whether otherwise sound disposal decisions should be deferred for tax reasons.

With direct equities, planners can control the realisation of gains — but only by not selling when other factors indicate this would be wise.

To achieve better net of tax returns requires the ability to identify as good a stock portfolio as a quality fund manager and to make better after-tax sales decisions. Few planners will be able to achieve this.

Broadly, the investment strategy with the lowest turnover will realise the least capital gain.

If this is held to be inherently desirable, is there any reason why a low turnover portfolio of direct shares is different from a low turnover managed fund? There are a number of managed funds that are focused on this.

MLCIncome Builder was established on the mantra of low turnover (as are index funds).

Dimensional takes a different approach, attempting to sell loss-making shares to realise sufficient capital losses to offset any realised gains.

Direct equities offer no apparent capital gains tax deferral advantages over these funds.

Consistently picking stocks that can outperform a market is not easy — one reason why there are so few superior fund managers.

Can planners obtain the required stock selection expertise from brokers’ research?

An aggrieved investor wrote a letter to an editor stating, “Half the brokers’ research is useless”. A retraction was demanded so the investor wrote again to the editor, stating, “Half the brokers’ research is not useless”.

Naturally I made the story up. If asked for a genuine view I would replace “useless” with “subject to conflicts of interest” and set the estimate above 50 per cent.

The huge fines imposed on US broking houses suggest many recommendations were not a genuine attempt to give good advice and, in extreme cases, were knowingly bad advice. The researchers’ roles were not seen as primarily to make money for clients but to serve the investment banking function of the firm.

Are Australian brokers subject to similar pressures?

A recent survey by theSecurities Institutefound 76 per cent of members believed barriers were necessary between research and other commercial activities. Most analysts, brokers and fund managers believed conflicts of interest were common.

In May 2002, theAustralian Financial Reviewfound that, on average, only 6.3 per cent of brokers’ recommendations were to sell. They also found that buy/hold/sell recommendations were broadly inaccurate and that the worst buy recommendations reflected a conflict of interest.

Many fund managers express the view that much broker research is of little value to them.ABNAMROhead of equities, Andrew Brown, is on record as saying, “A lot…goes straight in the bin”.

An industry colleague told me of his experience as a researcher in a broking house. On one occasion a broker told him he had a client who wished to sell a very large line in a given stock and asked for a report stating it was a strong buy, which could help to offload the stock.

The clearest sign of conflicts of interest is the lack of sell recommendations. In fact, sell disciplines are the biggest problem in direct equities.

Broking houses rarely express the view that any share is a sell, presumably because this alienates the company’s management, reducing the likelihood of obtaining investment banking business. It could also result in the analyst being excluded from corporate briefings.

It would be a brave and probably naïve planner who would entrust their clients’ investment returns to the hands of one or several brokers’ research departments. And who will advise when to sell?

Every planner knows the tendency of some clients to focus mainly on the assets that have done worst. Naturally the volatility of individual companies is much greater than that of a managed fund. Many investors will have had a holding ofAMPvia their managed funds but are unlikely to be specifically complaining about it, as they might if it was held directly. A managed fund moves the focus of the performance of individual shares onto the portfolio’s return.

Even if one adopts a never-sell-irrespective-of-value policy, direct equity portfolios are far more work, through turnover, rights issues, and so on. If one systematically sells, transactions are multiplied.

(For the purpose of this article, I would view a listed investment company as more like a managed fund than a direct stock.)

Most managed funds and most direct portfolios will produce broadly index-like returns. If your objective is to produce a superior return, the question is whether a quality manager has better stock selection and disposal skills than most planners.

If the fund buys and sells well it will incur tax — the same tax that an individual would pay. TheATOdoes not have two sets of tax laws.

Rob Keavney is chief executive of Centrestone Wealth Management.