Today, there are many different kinds of assets that investors can put their money into, however knowing the difference between them is important to understand whether you are making the right investment for you. Recent times have seen a strong rise and preference for ETFs which have become a staple in the arsenal of both individual investors and financial advisers. However, both ETFs and managed funds have distinctive advantages and disadvantages which must be weighed up before determining the right investment for you. To find out more about these types of investments and which may suit your current portfolio and investment strategy continue reading.
What are managed funds?
A managed fund can be described as the pooling of money from a variety of investors into one fund that is invested and controlled by a professional fund manager. These differ contingent on the specific asset classes such as shares or fixed interest as well as the level of risk such as growth or balanced funds.
When investors choose managed funds they are allocated a number of units, the value of each is called a unit price which changes on a daily basis according to the market. These funds can be listed which means they can be traded on the stock market, or unlisted which means that investors need to buy and sell units through a fund manager directly. Some of the common asset classes include cash managed funds, property trusts, Australian equity, International equity, fixed interest investments snd agricultural schemes.
What are ETFs?
ETF which stands for Exchanged traded fund is also a managed fund that is traded on the stock exchange. Similarly to managed funds, they provide investors with a range of exposure to domestic or international shares and bonds, as well as small or big-cap companies. ETFs work by tracking an index whereby the value of the ETF will move according to the index it tracks. Some indices ETFs track include the S&P500 and the ASX200.
It must be noted that there are some similarities between ETFs and managed funds including that they are both structured as trusts and therefore the assets are the legal property of the trustee for the benefit of the unit-holders. Each year unit-holders of either ETFs or managed funds are paid dividends and can realise any capital gain or loss from their investment. Investors in either type of fund are required to pay tax on these distributions contingent on their marginal rate.
What are the benefits of each investment?
There is a range of benefits associated with managed funds including that they are a low stress and low involvement investment. This enables individuals to have their funds managed by a professional with experience and access to information and research which may not be as available to individual investors.
Managed funds also make it easy for investors to ensure their portfolios are diversified as managed funds provide individuals with access to a wide range of investment types including shares, fixed interest, bonds or property. Managed funds also provide exposure to different industries and sectors both nationally and across the globe.
Another advantage of this form of investment is that it provides individuals with the opportunity to pool their money with other investors which grants them access to particular investments that may not have been available to them if investing individually. In conjunction with this, some managed funds have low minimum requirements on how much money you need to invest to join the fund, however, this will differ from fund to fund.
The main advantage of ETFs is that they generally cost less than managed funds and significantly less than buying direct shares. For example, a managed fund that offers investors exposure to companies around the world has a management fee of 1.35% p.a. Whereas an ETF that tracks an index of 150 global companies has a management cost of 0.35% p.a. whilst providing similar exposure. Thus, highlighting one of the key advantages of ETFs.
Similar to managed funds, ETFs also provide investors with the opportunity to gain broad exposure to entire markets and different asset classes to help investors reduce the effects of market volatility on their portfolios. ETFs unlike managed funds are fully invested and do not hold a small amount of liquid assets and therefore provide investors with full exposure to the market.
Another advantage of ETFs is that they are liquid and can be traded and bought on the stock exchange in the same way as direct shares. Similar to stocks, the dividends realised from ETFs can also be immediately reinvested allowing investors to continue growing their portfolios as a result.
ETFs also have the potential to be more tax effective in comparison to managed funds as ETFs keep turnover low which minimises capital gains and thus makes them more tax-effective over the long term.
What are the disadvantages of each investment?
The main disadvantage of managed funds is that the returns generated for investors are reduced due to the fees incurred for the active management of the fund which investors should consider before making any decisions.
Another downfall of managed funds is that most funds are ‘open ended’ meaning that when an investor wishes to cash in their units and realise the profit of their investment, the fund manager needs to sell some of the units to make the money available. The result of this is that some of these purchases or sales may not occur at the most optimal time for that individual investor. This could be particularly problematic where many investors are trying to cash in their funds simultaneously which may result in delays and thus causing your investment to be illiquid.
Another consideration that should be taken into account is the tax implications of holding units within a managed funds. As all units within the funds are taxed equally, you may be required to pay tax on your units even if you did not benefit from the capital gain. In addition to this, capital losses incurred through managed funds cannot be distributed to you to offset against capital gains realised outside of the fund.
It has also been suggested that there is less transparency around how your funds are invested within managed funds as fund managers are less inclined to provide regular and comprehensive information around the holdings within their funds. Hence, making it more difficult for investors to know where their money is invested.
Whilst there are many advantages of investing in ETFs it is also important to consider some of the drawbacks of this form of investment. As ETFs track an index it means that investors are not able to minimise the negative implications of market downturns.
Similar to direct shares, although ETFs may sometimes outperform the index there are times where they may do worse. Another disadvantage is that ETFs may be too narrow in their focus which increases the market risk borne by investors. ETFs that focus purely on single sectors such as technology or healthcare increase the negative implications of market volatility on investors, particularly if the ETF underperforms the index.
Another downfall of ETFs is that each time an investor wishes to buy or sell their shares in an ETF they will be charged brokerage. These fees will depend on which platform and the particular ETF the investor is choosing but often range between $10-$20 per trade. Therefore, if you choose to make regular investments of $500 a month, this equates to being charged an additional 3% of the amount you are investing in fees. Over the span of 12 months, this means $180 of a $6,000 investment is being swallowed up by fees. A way to combat this would be to purchase units in an ETF on a quarterly, bi-annual or annual basis.
All things considered, it is clear that there are both advantages and disadvantages which accompany each form of investment. When deciding between managed funds or ETFs individual investors need to weigh up the costs, benefits and risks of each and determine which is more suitable for their financial goals as well as the level of risk they wish to bear.
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