You can have your cake and eat it

A few years ago I went to invest some personal funds into a well-known and very popular retail managed fund.

The investment was in my name and it was for the long term. As I was earning more than $50,000 per annum, I wanted capital growth, not income, and I wanted to minimise my tax (legally of course!).

Now this fund had a great track record, everyone used it and its stated objective was capital growth. So I invested my money in April. The end of the financial year was fast approaching, but it came and went without me noticing. A few weeks later I received a tax statement for my investment. Attached to the statement was a cheque — a large cheque.

Although I had only been an investor for three months, I had received a very large distribution (more than 20 per cent of my original investment).

Initially I was impressed that the fund manager could generate such large income in such a short time, but upon further investigation I realised the distribution was for realised capital gains generated by the fund during the last 12 months.

My cumulative unit price had not gone up, in fact it was about the same price it was when I invested. Nonetheless, I was given a large distribution of realised capital gains in which I did not participate.

It gets better. I had to include the distribution in my assessable income and I paid tax at the highest marginal tax rate. In summary, I invested my money, received a large distribution, paid tax and ultimately lost to the tax man approximately 10 per cent of my initial investment. All for a capital gain that I did not benefit from.

In some years investors can receive a large distribution for realised gains yet the value of their capital falls.

This is a real problem for managed funds, particularly unit trusts, and as investors are very sensitive to tax, the issue will not go away.

For years advisers have also used managed funds to invest their clients’ money. Some advisers just use managed funds and others just use direct investments and some use a combination.

The question is, what is best for the client?

Are managed funds superior? Are direct investments better or is there an even better investment vehicle?

A managed fund provides the adviser and the client with a very simple and convenient way to invest.

Managed funds are enormously popular in Australia. With over $300 billion in funds under management, investors are spoiled for choice. All they need is advice to choose the right managed fund.

A managed fund is popular with advisers because:

n there are many to choose from;

n they are easy to use;

n the minimums are low, providing significant diversification;

n they provide a reasonable level of liquidity;

n they provide access to the services of professional money management; and

n they provide an easy method of remuneration via commissions and trail fees.

But when I consider the features of a managed fund, I am still convinced that there must be a better way of investing because:

l managed funds are managed to meet the fund’s objectives not the investor’s;

l managers are evaluated on performance against a benchmark with no reference to after-tax results — most investors want to maximise after-tax returns;

l high portfolio turnover and short-term holdings may create taxable distributions;

l investors cannot control timing of tax liabilities;

l investors cannot exclude certain stocks or sectors from the portfolio; and

l if the fund experiences high redemptions, it may be forced to sell securities resulting in distributions to the remaining investors.

Any stockbroker reading this will say that opening a brokerage account and investing directly in shares will overcome the problems of managed funds. They are right, but by investing direct, investors lose some of the benefits of managed funds and they are the big ones.

For example, with a brokerage account, I do not get the services of a professional money manager employed by a specialist investment management organisation to manage my portfolio on my behalf.

My broker may be good at selecting my stocks, but I want the same manager who is managing money for the large super funds and other institutional investors. And since I believe in professionally managed money, I would like to have an investment vehicle that provides both the benefits of managed funds and the advantages of direct shares.

The answer is an individually managed account (IMA). An IMA provides all the appeal of a managed fund but can significantly overcome all of its weaknesses. An IMA is simply a client’s own managed fund — they are the only unit holder. They own the stocks in their own name and a professional money manager manages the portfolio.

Although we are only just starting to see the first generation of IMAs arrive on the retail market now, IMAs are in fact, nothing new.

Institutional investors have been using them for years, usually with portfolios of more than $10 million. With the advent of technology, IMAs will be available to the retail investor for portfolios as small as $50,000.

The IMA combines the benefits of managed funds together with the benefits of share ownership.

The advantage to the investor is that it is a better vehicle for investing than managed funds because it gives them greater control.

This control centres on the ability to finesse the tax position of the portfolio. That is, when an investor sets up an IMA and gets a portfolio of 20 to 30 stocks, the cost base of those stocks for tax purposes is set when the IMA purchases the stocks, whereas when you invest in a managed fund there are two cost bases for capital gains tax purposes.

The investor’s cost base is the Net Asset Value (NAV) of the units in the managed fund/trust that he has purchased and secondly, the unit trust has a cost base of the stocks it already holds (this is often called the ‘embedded’ capital gain in the NAV).

This is what happened to me — I bought a unit trust that had large embedded capital gain in its NAV. When you use an IMA you do not inherit embedded capital gains.

An IMA, therefore, offers the advantages of managed money and also provides benefits that a managed fund cannot. So, I can have my cake and eat it too.

Stephen Robertson is a retaildistribution and productspecialist.