The first step to investing in any Fund is to understand it. Whether it’s an unlisted fund, an exchange traded fund (ETF) or a listed investment company (LIC), here’s ten questions for any managed fund to get you started. If you can answer these, you will have a good understanding of what the Fund does. This can help you to identify what role it might play in your investment portfolio.
What is the structure?
Other than LIC’s, most investment funds, including ETFs, are a special type of trust called a managed investment scheme. The main reason to understand the structure is to be aware of the tax consequences. Companies such as LICs pay tax on their net income and any realised capital gains. They pay income to their investors by way of dividends. If they’ve paid tax, those dividends come with franking credits, which are a way of giving the investor credit for the tax previously paid for by the company. Trusts, on the other hand, pay no tax directly. Instead, they calculate the amounts that would be taxable if they were to pay tax, and advise those amounts to investors by way of an annual tax statement. So, companies pay tax and the investor gets the credit. Trusts pay no tax, but the end investor does. Confusing.
Is the investment strategy passive or active?
Passive, or index investing means investments are made mostly in accordance with a predetermined policy, in order to replicate the performance of a benchmark (for example the ASX 200 index) less fees. Passive managers achieve this by buying each individual stock that forms part of the index. For example, an ASX 200 index fund may seek to own all 200 shares in the index, each with the same proportionate weighting as the index.
Actively managed funds, such as those in the Affluence Investment Fund do not track a benchmark or index, but instead have more freedom in what assets they purchase and their weightings in the fund. Therefore, whether the fund outperforms the relevant benchmark is down to the skill of the investment manager.
Active funds have the potential to significantly outperform a passive fund, and likewise to significantly underperform as well. Most active managers underperform after fees. But that’s usually because they’re not really that active after all – their portfolio deviates very little from the market they invest in. One way to identify how active a manager is can be to look at a graph of their returns compared to the index or market they aim to beat. If it looks, very similar, chances are they are an imposter – a fairly passive manager pretending to be active. In this case, you’d probably be better off with a low fee index fund.
Who is the management company?
The investing activities for a Fund or an LIC are normally overseen by specialist investment managers which are usually companies. These investment managers are appointed by the board of an LIC or the trustee (sometimes called a responsible entity) of a Fund. The investment manager may be the same as the trustee or a separate entity. The investment manager appoints one or more investment staff (usually known as fund managers or portfolio managers) who undertake the day-to-day investing activities for the Fund.
Who makes the investment decisions?
For active funds, we consider the fund managers or portfolio managers for each fund, not the directors or management company, to be the most important factor in delivering long term returns. It is therefore important to understand how long an investment team has been together when assessing performance of a fund. If the fund has existed for longer than the current key fund managers have been in place, it may be wise to discount or even ignore any performance data from earlier periods. Performance is usually very much influenced by the team running the portfolio and making to day-to-day investment decisions.
We like to see stability in the investment team and strong alignment. Some key factors which may indicate a strong alignment of interest include fund managers owning part of the management company, significant personal investments in the Fund and where a fund manager has a long history managing the fund.
What assets does the Fund own?
You should take time to understand what types of assets the fund invests in (e.g. shares, property, diversified). There are usually limits on the types of investments the fund can make. These are sometimes known as the “investment universe”. Within an asset class, there may be limits on the markets, sectors or countries the fund can invest in. There may also be other limits in place to manage risk, such as a maximum size for a single investment, or limits on the ability to gear, short sell or use derivatives.
Investment limits can be a good thing, so long as they’re there for a good reason. In some cases, these limits can be overly restrictive, leading fund managers to own an investment they don’t like just because it forms part of a market index or investment universe.
How do you buy and sell the Fund?
Listed funds, LICs and ETFs can be bought and sold on ASX through your broker in the same way as other shares. When you buy a listed fund on ASX, you’re buying from another investor.
Unlisted funds require an application process. While that can happen online for most funds, it may also require investor identification documents to be provided, which means the process takes longer. Unlisted funds may also accept applications less often – perhaps weekly or monthly. When you buy or sell units in an unlisted fund, you’re transacting with the fund itself, which either issues units to you, or redeems (cancels) them.
Is pricing market based or net asset value based?
Unlisted funds are almost always priced at net asset value. This is calculated as the price of all the fund investments divided by the number of units issued. This means investors know that the price they pay or receive reflects the value of the underlying assets. Most listed funds and ETF’s also trade at a price very similar to the net asset value, aided by a market maker who helps ensure this occurs.
On the other hand, most LICs trade at a price determined by market forces and set by buyers and sellers. This can differ quite a lot to the underlying net asset value. This represents both a risk and an opportunity for LIC investors. It’s something we seek to take advantage of in our Affluence LIC Fund.
What are the fees and costs?
In return for running a fund, the investment manager and/or trustee charge a fee to for their services. Fee structures can vary considerably, but typically include a base fee. This is usually a fixed percentage of the net assets of the fund. Investment managers may also charge a performance fee (usually a percentage of the returns above a target level). Performance fees are usually subject to a high-water mark. This means any underperformance against the target returns must be regained in the future before any further performance fees can be charged.
A Fund will also typically pay administration and running costs. In some cases, the manager will agree to pay these out of their management fees. In other cases, particularly for smaller Funds and some LICs, these costs can be quite high.
You will usually also pay a buy/sell spread when investing in an unlisted Fund or a bid/ask spread when investing in a listed Fund/LIC. These are one-off costs, but they may be important if you trade in or out of Funds regularly.
How might the Fund perform in different markets?
This is one of the most important things we seek to understand of any fund. What markets is it most invested in? How will it perform in different market environments? For example, a fund that invests in ASX stocks but also carries a reasonable amount of cash might be expected to increase less than the ASX when the ASX rises strongly and fall less in down markets. The asset class, geographic and currency exposure, cash, gearing, use of short selling or derivatives, investment style and risk limits can all have an impact on how a fund might perform in different market conditions. Reviewing historic performance can help, but it’s a good question to ask the fund manager directly.
How are returns generated?
Investors usually receive returns in two ways. Firstly, most funds pay distributions to investors (LICs pay dividends). These distributions or dividends are usually determined and paid just once or twice a year. Some Funds, for example property and fixed interest funds, can pay more regularly. Secondly, the unit prices of managed funds or the ASX price of ETFs and LICs will increase or decrease over time based on changes in value of the underlying investments the fund holds. When the value of the funds’ underlying investments rises – so will the unit price of that fund. Similarly, a fall in the value of the underlying investments will lead to a fall in the unit price.
So, the total returns to an investor in a managed fund will consist of the distributions they receive, plus or minus the change in the price of the fund units.
Understanding the answers to each of these questions is a good start. But there’s a lot more work we do before we invest in a managed fund or LIC. Our guide to managed funds and guide to LICs explain what we look for in more detail.
Take care and all the best with your investing.
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