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Watch your neighbour in managed funds

This short series looks at some product shortcomings which could materially affect whether an investment is appropriate. An investor wanting a broad exposure to the market in a single investment has three main alternatives: unlisted managed funds, listed investment companies (LICs) and exchange traded funds (ETFs). We will focus on some weaknesses in each of these three product types. The first part in the series looked at LICs, and this article goes inside managed funds.

The main problem for unlisted managed funds is that investments are combined with all other money in a pool, and the actions of others in the pool can adversely affect an individual. The ‘open-ended’ structure requires shares to be bought and sold within the fund as investors come and go. This contrasts with a ‘closed-ended’ product such as LICs where purchases and sales are made on market with other investors.

In the industry, it’s called ‘watch your neighbour’ – what are other investors in the pool doing?

Examples of unwelcome impacts of pooling

The pooling of investors can have a significant impact on the returns of an individual.

1.  Capital gains tax liability

When an investor withdraws from a fund, some shares may be sold to meet the redemption, potentially creating a capital gains tax liability. However, the capital gains liability does not go to the departing investor, but is left for those remaining in the fund when distributions are made. This can be a particular problem if many investors leave and few remain. When the fund makes its distribution, a large taxable capital gain liability may fall on the ‘last man standing’. In other words, because investors move into and out of managed funds at different points in time, taxation liabilities in respect of gains that benefited past investors may be passed on to subsequent or remaining investors.

2.  Loss of franking credits

Franking credits are only paid to investors receiving a distribution, and the value of the franking is not included in the unit price. An investor who departs a managed fund just prior to distribution leaves the full franking behind, and this may be a material part of the entire return. In fact, those in the know can arbitrage the fund if they know a large franking credit exists for a limited number of investors at distribution time. (Note, one fund recently started grossing up its unit prices for franking credits).

3.  Managers forced to sell as investors panic

Investors are notorious for selling when the market falls and buying when the market rises. This can be problematic for open-ended funds because portfolio managers may be forced to sell even when they think the market offers excellent value. If they have to meet redemptions and no new money is coming in, it does not matter what the manager thinks about the market. They become frustrated net sellers at discounts to their own valuations, then as the market recovers and inflows return, they become even more frustrated having to invest at higher prices. While one investor can remain patient, the fund is forced to act due to other investors in the same pool. A closed-end fund does not need to meet redemptions when prices are low nor invest when prices are high.

4.  Unrealised gains or losses

There is no allowance in the unit price for unrealised gains and losses in the portfolio, and this can have implications for the future taxation of the fund. Two funds may be otherwise identical but the one with large unrealised gains will give a higher capital gains tax liability to its investors after shares are sold than the one carrying unrealised losses.

5.  Suspension of withdrawals

During times of market disruption, such as experienced by mortgage funds during the GFC, the liquidity of the underlying assets may not be sufficient to match the level of redemption requests. The fund manager may have no choice but to suspend redemptions. Managers advise in their PDS something like:

“Any decision whether to process withdrawals will be made in the best interests of investors as a whole. Under abnormal market conditions, some normally liquid assets may become illiquid, and we may restrict or delay withdrawal payments.”

Again, the actions of some investors in panic mode may lead to the suspension of redemptions for the more patient and calm investors, and if the latter need to withdraw for some reason unrelated to the market, their funds might not be available.

6.  Converting capital to taxable income

Distributions from a managed fund are based on the number of units that an individual owns on the distribution date in proportion to all units in the fund. The unit price (similar to the price listed on the ASX) of the fund will fall by the amount of the distribution immediately after it is paid. An investor buying units immediately before a distribution may be generating a tax liability without a return on the investment. For example, assume a unit price of $2 and a 10 cent distribution on 7 July. On 8 July, the unit price falls to $1.90 and the investor may receive a taxable distribution of 10 cents. Capital has been converted to taxable income due to the timing of the investment.

Your neighbour can bite you

Managed funds are far more complicated than most investors realise, and behind the scenes, trustees often have to deal with problems related to fair treatment between unitholders. The investor who does not know the portfolio’s realised and unrealised capital gains, the potential loss of franking credits, the timing of distributions, the inflows and outflows of the fund and the risk of suspension is buying into a world of uncertainty.

 

Note that Graham will be presenting on SMSF Portfolio Construction at the SMSF Owners' Alliance Technical Workshop on 9 October 2014 in Sydney. For the full agenda, please see www.smsfoa.org.au.

 

Graham Hand was General Manager, Capital Markets at Commonwealth Bank; Deputy Treasurer at State Bank of NSW; Managing Director Treasury at NatWest Markets and General Manager, Funding & Alliances at Colonial First State. Nothing in this article constitutes personal financial advice.

 

 

4 Comments
BetaShares
July 01, 2017

Hi Lyn, ETF providers generally employ a concept known as “streaming” when dealing with redemption events. Only certain financial institutions are allowed to create and redeem units directly with the ETF provider (other investors buy and sell units on the stock exchange) and whenever they redeem units, any realised gains generated directly as a result of selling down assets to meet the redemption may be “streamed” or passed through to them directly. This means that the remaining unit holders should not have these taxable gains passed through to them as part of any future distributions.

Indeed one of the oft cited benefits of ETFs is their tax efficacy relative to managed funds, with streaming being one of the areas of difference in this regards

Lyn
June 29, 2017

Hello

I have a question about CGT liability when invested in a managed fund. Is it possible to receive a CGT liability higher than the distribution you receive? My question comes after reading the following extract from an article written by Graham Hand on 10/9/14 titled "Watch your neighbour in managed funds."

"Capital gains tax liability: When an investor withdraws from a fund, some shares may be sold to meet the redemption, potentially creating a capital gains tax liability. However, the capital gains liability does not go to the departing investor, but is left for those remaining in the fund when distributions are made. This can be a particular problem if many investors leave and few remain. When the fund makes its distribution, a large taxable capital gain liability may fall on the ‘last man standing’. In other words, because investors move into and out of managed funds at different points in time, taxation liabilities in respect of gains that benefited past investors may be passed on to subsequent or remaining investors."

And I have the same question in regard to ETFs. Are they affected in the same way?

I would really appreciate a response. I would like to invest in managed funds or ETFs but don't want to leave myself open to that particular risk, if that is the case.

Thank you in advance for your time.

regards, Lyn

Warren Bird
May 03, 2017

There have been workarounds that the more client-focused managers have used to reduce the impact of some of these. EG where a large redemption from a fund would leave a large amount of income in a trust that the remaining unit holders would become entitled to, the trust could pay a special distribution so that the exiting investor got paid their share of the income.

However, there's been a change in the tax law that addresses many of these issues more effectively. The Attribution Managed Investment Trust regime was introduced in 2016. It's an opt in system for the fund managers that, among other things, means that they don't have to do workarounds and can attribute income to unit holders through the distribution period rather than having to treat those who are in the fund on 30 June as being 'entitled' to all the distributable income.

I'm not an expert on this. I've had to think about it for our managed funds at UFS. But i do think that every investor who uses managed funds should ask their advisers to check in with the managers they use about whether they're opting in or not.

(Graham - suggest Cuffelinks might get an expert to write some more about this.)

Oscar P
September 12, 2014

Thanks I will be talking to my adviser about these he never mentioned them before

 

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