Know your alternatives for Australian equities

Managed funds are the most common ways advisers recommend clients build stakes in Australian shares.

But other options including listed investment companies, direct shares and exchange traded funds all provide investors with a diversified exposure to Australian shares.

However, they have differences in cost, structure and diversification. Advisers need to be aware of these differences before they can develop options best suited to their clients.

Unlisted equity funds

Unlisted equity funds (managed funds) provide diversified exposure to a range of Australian Stock Exchange (ASX)-listed companies. Given their trust structure, all income and realised capital gains are distributed to investors.

Fund managers strike unit prices daily to reflect the value of the underlying portfolio. Units are transacted at the calculated buy and sell prices. Unlisted unit trusts are available in both retail and wholesale form, with the key differences being cost and size of minimum investment.

Most major managed fund providers tend to offer portfolios that reflect to some degree the composition of the Australian share market. There are some managers that are prepared to back their judgement and take on higher levels of active risk.

Listed investment companies (LICs)

With these companies, tax is paid at the company rate and franked dividends may be distributed to investors.

These companies are also entitled to tax concessions on capital gains from stocks held for more than 12 months.

They appeal to investors seeking a simple, low-cost, diversified exposure to Australian shares.

Unlike managed funds (where the unit price reflects the value of the underlying portfolio), LICs can trade above and below fair value.

Their prices reflect both the underlying fundamentals and market sentiment.

Recently, a number of ‘new generation’ LICs have been launched. While they charge higher management expense ratios (typically 1.25 per cent -1.75 per cent a year) and performance fees, they also offer new opportunities.

Some of these managers have an absolute return focus and run high conviction, concentrated portfolios that fully reflect their research view. If they can get enough of these selections right, the additional costs may be justified.

Many of the most recent LICs also issued options on a one-for-one basis.

While this makes sense from a funds management perspective (each option exercised will result in additional funds under management), it is hard to see the benefit for a typical investor.

LICs provide monthly updates to the ASX detailing the net asset backing, investment strategy and a summary of major holdings.

As well as keeping the market informed, this information helps investors to make an assessment about whether current prices reflect fair value.

Direct shares

The stock-specific risk of direct purchase shares is higher because holdings are typically more concentrated than with a managed fund.

This approach is well suited to clients seeking direct control over their tax position or those who wish to generate extra income by writing call options over some of their stocks.

For clients following a buy and hold strategy, this approach also has the added advantage of being low-cost compared with managed funds.

Exchange traded funds (ETFs)

The ETFs available in Australia typically come in index form. The few actively managed ETFs we have seen have not been highly attractive.

Index-based ETFs are ASX-listed investments. They are considered a good choice for investors seeking a low-cost, passively managed, tax effective and highly liquid investment.

The structure of ASX-listed StreetTracks products has ensured that arbitrage by professional investors helps to keep the market price very close to their net asset backing (NTA).

This overcomes one of the key problems with ETFs.

Costs can be under 0.3 per cent per annum for an ETF that tracks the Australian market. This would be an attractive price for retail investors.

The table (right) summarises the key differences between these four equity investment options.

It highlights some of the areas advisers need to consider when developing the best options for their clients.

What to consider:

Taxation

Historically, investors who pay little or no tax have been better off under a trust structure rather than a company structure (where tax is paid at the company rate). However, this is now less of an issue.

Investors can gain a full refund of unused imputation credits and also receive concessional tax treatment for gains on stocks held for more than 12 months.

Direct shares, ETFs and index managed funds offer the best control and certainty regarding the tax outcome.

Unlisted equity funds are the weakest in this regard and large distributions of realised capital gains are not uncommon.

Structure

The ‘open ended’ structure of unlisted equity companies means that fund size changes with inflows and outflows. This can be challenging for fund managers, adds a layer of complexity and can result in higher than optimal trading costs.

LICs have a significant advantage in this regard since they are ‘closed end’ funds.

Of course, cynics would say that LICs have a mandate ‘you can never lose’ since investors cannot redeem. They can only sell their shares to someone else.

Net asset backing (NTA)

When market sentiment is poor, listed equity companies often trade below NTA. This is the price payable per share, if the total portfolio was to be sold. When sentiment is strong, listed investment companies often trade above NTA.

Investors should be cautious about paying more for the assets than their underlying value.

Some of the smaller, less liquid issues tend to trade below NTA in most conditions. This presents some opportunities.

Cost

Direct shares, ETFs and listed equity companies are all relatively attractive from a cost perspective. Retail unlisted equity funds are more expensive, but offer features (such as regular savings plans) as well as paying trail commission to advisers.

Wholesale unlisted equity funds are considerably cheaper than their retail counterparts.

The issue of cost should be balanced against the benefits offered by the particular form of investment, such as rebalancing, minimum investments, reporting, monitoring and diversification.

Liquidity

Most investment structures offer high levels of liquidity. Smaller companies and active ETFs are the exception.

Generally, investors could expect to receive the proceeds of a sale within a matter of days of placing a ‘sell order’ with a broker or fund manager.

While not a major issue for most investors, ASX-listed investments allow investors to sell out intra-day rather than just at the closing price for the day. Some more tactical investors see this as a significant advantage.

Thinly traded issues can present liquidity challenges, however, they can also provide opportunities for aggressive investors.

Choice

Clearly, choice is not an issue with equity funds and direct shares. The choice within listed investment companies is improving and this will continue.

ETFs are relatively new, but given the index approach there is little need for additional choices. For ETFs, the key issue is cost — the cheaper the better.

Style

There are major differences with regard to investment approach. ETFs are usually passive. Style is not an issue since investors receive diversified exposure to the market index.

LICs are the most active and seem less concerned about benchmark risk.

Many institutional, actively managed, unlisted equity funds have a strong focus on business risk and are unlikely to take very large exposures.

Direct share portfolios are usually the most concentrated and would generally be considered the most aggressive approach.

Performance

Performance comparisons are difficult due to tax treatment. Returns for LICs are tax paid, while unlisted equity funds are pre-tax.

Not surprisingly, the managed funds industry has data to support the case that unlisted managed funds do best. The larger listed equity companies have their own data challenging those claims.

Conclusion

Retail equity funds remain a good option for clients requiring regular savings plans. Wholesale equity funds offer cost advantages for clients who have no need for these plans. As wholesale funds do not pay commission, advisers would need to charge ‘fee for service’ or access these funds via a master trust or wrap platform.

Some LICs are cheaper than their unlisted retail counterparts. However, they can trade at a premium to NTA — so caution is required. LICs trading below NTA can appeal, however, advisers need to be aware that a cheap LIC can always get cheaper.

Direct shares remain a robust approach for those seeking control and transparency, and who have particular portfolio requirements that cannot be adequately met by other alternatives.

Stock-specific risk is higher when using direct shares, so advisers need to ensure that portfolios hold sufficient stocks to offer at least a minimum level of diversification.

ETFs can be a good option for passive retail investors given significantly lower MERs than traditional retail index funds.

For wholesale investors, the position is less compelling since wholesale index funds are relatively cheap.

The key point with all of this is that when it comes to investing in Australian shares, advisers have a number of quality options to recommend to their clients.

Hamish Trumbull is senior research analyst with AXA Australia .