David Benney looks at the advantages and disadvantages of direct shares versus managed funds.
Financial advisers are often asked by their clients if owning some direct shares along with managed funds is a good idea. In particular, clients who choose to use self-managed super funds (SMSFs) are increasingly asking questions about having at least some of their SMSF invested in direct shares.
There are first-class aspects of managed funds that cannot be replicated by direct shares. Managed funds are suitable for international investments, and are a cost-efficient way to access asset classes such as bond funds, cash trusts and property trusts.
But this article addresses the key differences between Australian equity managed funds and a directly held Australian equities portfolio.
Managed fund fees, advice fees and the value of advice
Typical fees associated with managed funds are the management expense ratio (MER), buy/sell spreads, internal portfolio transaction costs, performance fees, arranger fees and platform shelf space fees.
Product fees and adviser remuneration are of paramount interest to clients and have come under increasing regulatory scrutiny.
Direct shares have fewer layers of product fees associated with them as a financial product, and the fees tend to be more transparent.
There is a transaction fee attached to the buying and selling of each parcel of shares, usually termed brokerage, which is comparable to the implementation fee an adviser may charge to buy or sell managed funds.
Of the remaining internal product fees, there is usually no ongoing MER, performance fee or platform fee.
There is also a buy/sell spread that is usually the difference in the share price on the Australian Securities Exchange (ASX) for buying or selling shares.
With electronically traded and highly liquid blue chip shares, this buy/sell spread is often very low — sometimes only 1 cent per share. However, fees are only one point of difference between direct shares and managed funds.
Transparency, liquidity, portfolio valuations and capital gains tax
Another benefit to clients of holding direct shares is the transparency of portfolio holdings.
Both during and after the global financial crisis many investors were extremely concerned about where, in which sectors and in which countries their investment funds were placed.
A direct share portfolio is transparent and all holdings can be viewed live via most platform or stockbroker websites.
A natural benefit of transparency, apart from client peace of mind, is that if the direct portfolio does contain a bad investment, that holding can be identified and sold separately.
While managed funds can be redeemed or purchased at any time, it is usually at least a 24-hour process.
The unit holder is required to sign and fill out a redemption or purchase form, which is then placed by their adviser.
A direct share portfolio can be bought or sold at any time during ASX trading hours, and share prices are valued live by the market every second.
Funds managers are usually making many buy and sell decisions each year within their managed fund.
This activity generates transaction costs (share brokerage) and capital gains or loss events.
At the end of the investment period the total capital gain or loss is calculated, capital gains tax (CGT) is paid to the Government on behalf of unit holders, and a statement is provided to unit holders with the details.
Within that annual statement any dividend franking credits accrued to unit holders are also added.
If a fund is considered to be active (ie, 100 per cent or more total fund turnover each year) then franking credits for holding shares six months or longer may be low.
A less active fund will likely collect more franking credits and incur less CGT than an active fund, but this information is not made available to the unit holder until after the end of the financial period each year.
A direct share portfolio’s level of buy/sell activity can be controlled by the adviser and client, hence the amount of CGT and franking credits can also be controlled, usually to maximise the benefit to the client.
SMSFs and investor sophistication
Most advisers would agree that SMSFs are a rapidly growing part of our industry.
It appears that many clients with larger superannuation fund balances (ie, more than $100,000) are seeking diversification of their portfolios, which is why they are running their own fund.
If you advise clients in this space, you will likely notice they are becoming more sophisticated in their education about investments, and often seek exposure to direct shares.
This is not always the best solution for clients, but in order to offer a complete service planners should be able to offer their clients a choice between managed funds and direct shares.
Business issues with direct shares
Key issues associated with offering direct shares as a financial product to clients are:
- who gives advice on stock selection?;
- who is managing the portfolio on an ongoing basis?;
- who will conduct the share transactions?;
- what universe of stocks are to be advised on and what research is used?;
- which shares are suitable for clients with different risk profiles?;
- who or what platform is maintaining the register of shares owned, collecting dividends and measuring performance?;
- who gives advice and makes changes to account for corporate action events such as takeovers, rights issues and share purchase plans?; and
- who maintains active knowledge of shares being held by clients and hence the suitability to retain or change those individual stocks?
Business potential
Financial planners who provide professional access to a direct share offering for their clients are broadening their client experience.
There are some structural benefits to direct shares as an investment product over managed funds in some areas.
Australian equity managed funds typically invest in direct shares to generate their investment returns, so the end investment is often the same stock.
As clients become more sophisticated and seek a better after-tax investment return, they will appreciate a wider selection of investments from their financial adviser.
Planners can protect their existing client base by providing shares as an extension to managed funds. By broadening their product base they can grow their practice and cater to a greater market.
David Benney is principal consultant at Godfrey Pembroke Financial Consultants.
