Introduction to managed funds

A managed fund pools together people's money to invest in a range of investments, such as shares, property or fixed interest.

Managed funds may provide a cost-effective way for investors, large and small to access a diversified mix of investments. As your money is pooled with others you can invest in a range of assets that might be too difficult or expensive to invest in directly yourself.

A professional fund manager invests your assets based on the fund's investment strategy and objectives. This means you don't have to worry about selecting which companies or securities to invest in.

Instead of owning the investments yourself, like when you buy shares directly, the managed fund owns the underlying investments on your behalf. Each investor is allocated units representing their share of the fund. The value of your units fluctuates with the value of the underlying investments, which is reflected in the unit price.

There are many different types of managed funds offering a range of investment objectives and strategies. Total managed funds assets in Australia are currently $1.37 trillion* and make up a large proportion of assets under management in superannuation funds.

* Source: Morningstar Australian Asset Flows – March quarter 2015.

Choosing your investment strategy

With the wide choice of investment options available today how do you know which is the right strategy for you? You can choose from single sector funds like Australian share and international share funds, or diversified or multi-sector funds that include a mix of sectors like shares, fixed interest and property.

Here are some factors to consider before choosing your investment strategy.

Investment types and risk

All investments carry some level of risk. The type and degree of risk will vary depending on the investments you choose. The trade-off for higher risk is usually a higher potential return.

This graph shows the relationship between risk and return for each asset class. Risk is typically measured in terms of the likelihood of achieving a negative return in any one year - the higher the risk level of an asset class the higher the likelihood of achieving a negative return.

Higher risk asset classes like shares are long-term investments, which means the longer you invest the less likelihood of your investment value falling. Not taking sufficient risk can be a risk in itself. For example, cash investments are less likely to grow over time and may not meet your long-term objectives.

Potential return

Diversification

Spreading your money across a range of investments is one of the best ways to reduce your exposure to market risk. This way you are not relying on the returns of a single investment. Investment markets move up and down at different times. With a diversified portfolio of investments, returns from better performing investments can help offset those that underperform.

Holding a broadly diversified portfolio can also improve your performance potential and increase your chances of achieving market growth.

Getting your asset allocation right

Research confirms that how you allocate your assets to each asset class is more important to long-term performance than the individual stocks you choose.

Some investors prefer to leave the asset allocation decision up to a fund manager and invest in a diversified fund so they don't have to worry about monitoring and rebalancing their portfolios.

Investors who want more control over their investments may decide to make up their own asset allocation by selecting individual asset class funds. If you decide to use this approach, you will need to be disciplined and monitor your investments on an ongoing basis and rebalance your investments in line with your asset allocation targets. Alternatively, you could ask your financial adviser to do this for you.

Your investment profile

Before choosing your asset allocation you will need to consider factors such as your:

  • Short, medium and longer-term investment objectives.
  • Investment timeframe.
  • Attitude to risk and return.
  • Current circumstances, limitations and future prospects.

The above factors will help you, or your adviser, identify your investment profile so you can determine the most suitable asset allocation for your needs.

Risk/return profiling is a tool used by professional and novice investors alike when determining investment profiles. It can be a detailed and individual process, so it is best completed under the guidance of a professional financial adviser.

Sometimes life doesn't go to plan. So, it's important to review your investment strategy if there are any major changes in your circumstances. If you need help, a professional financial adviser can determine the best investment strategy for your investment timeframe, objectives and personal circumstances.

Cash basics

Cash plays an important role in an investment portfolio. As a stand-alone investment cash typically suits investors with shorter investment timeframes or those who need access to their funds.

Typically, cash investments aim to provide income, liquidity and stable returns. Cash management trusts and funds usually invest in a range of short-term money market investments (that usually mature in 12 months or less) and provide the potential to earn higher returns than bank accounts and term deposits.

Types of investments

Cash investments can include term deposits, money market securities and cash management trusts. Term deposits usually offer higher returns than traditional bank accounts to compensate for the longer investment term. Usually, the higher the interest rate on offer the longer you need to lock your money away and the higher the risk.

Risk/return characteristics

Cash has the lowest risk of all asset classes. In fact, the 90 day treasury note interest rate is often the yardstick for a risk-free rate of return in Australia.

The short-term nature of cash investments makes them less volatile than other types of asset classes. While it is unlikely that the value of your capital will fall, you do risk the possibility of your capital not keeping pace with inflation, and losing value in real terms.

The level of income from cash investments varies as interest rates move up and down. Interest rates typically rise with inflationary expectations. It also depends on the types and maturities of securities held.

Accessing cash investments

You can access cash investments directly via bank deposits, debentures and bank bills or indirectly via cash management trusts and managed funds. Managed funds provide a way of accessing a diversified portfolio of securities, which can include securities with different issuers, maturities and credit ratings.-

Fixed interest basics

Fixed interest may provide a buffer against volatile share markets when held in a diversified portfolio.

Fixed interest securities

Fixed interest investments can be issued by the Federal government, state governments, semi-government authorities, banks and other corporations, both locally and overseas, to raise capital for projects.

Fixed interest investments usually have longer investment terms than cash investments. Australian bond maturities usually range from one to 10 years while US bonds can extend up to 30 years.

Investments in both international and Australian fixed interest securities have two major benefits for investors. It increases diversification, which lowers risk, and it provides opportunities for enhanced returns without resorting to lower grade, higher risk debt. The international bond market comprises over 12,000 securities compared to about 500 in the Australian market*.

Types of fixed interest securities

The main types of fixed interest securities are:

Government bonds - issued directly by a government. For instance, in Australia the federal government issues commonwealth securities to help pay for major government projects.

Semi-government bonds - not issued directly by a government but might have a direct or implied guarantee. For instance, state governments and other entities that have a government guarantee (like the World Bank) issue bonds to support their financial needs or to finance public projects.

Corporate bonds - issued by large public companies to fund expansion and other major projects. Corporate bonds differ in two important ways to government bonds - yield and credit quality. Generally, corporate bonds are thought to have a higher level of risk than government or semi-government bonds, so they typically offer higher interest rates.

Hybrids - have characteristics of both equity and fixed interest securities. Convertible bonds, for example, commence as bonds but can be converted into equity at a future date. These types of securities have higher risk than government or corporate bonds as they are less secured. This means they come further down the repayment line if the issuer defaults on the loan.

How fixed interest markets work

Bonds operate like an IOU, whereby you lend your money to the issuer for a set period of time, in return for interest paid over the term of your investment. Your investment, or capital, is then paid back to you in full at the end of the investment term.

Fixed interest securities can be traded on the secondary market before their maturity. This is usually how bond funds are managed. Fund managers trade securities with the aim of profiting from price fluctuations.

Risk/return characteristics

Fixed interest is a low- to medium- risk investment suitable for investors with a timeframe of three years or more.

In addition to providing a regular income stream - an important feature for many investors - fixed interest may provide a stabilising effect during periods of share market volatility.

Total bond returns can include income from interest payments and growth from price fluctuations. Bond yields are inversely related to bond prices. When bond yields rise, bond prices will fall and vice versa.

Bond yields and prices may fluctuate regularly based on the economic outlook. Bonds can provide capital growth (and loss) when sold prior to the maturity date for a higher (or lower) price.

Credit risk refers to the risk of an issuer defaulting on repayment of capital. Credit ratings provide a good indication of the risk level associated with the issuer. Bond issues are rated by independent rating agencies like Standard & Poor's. The higher the rating the less likelihood of the issuer defaulting on repaying your capital. Usually, the higher the risk, the higher the yield.

Accessing fixed interest markets

You can invest in fixed interest investments directly or through a managed fund. Managed funds provide a way of accessing a diversified portfolio of securities, which can include a mix of Australian or international government and corporate fixed interest investments, or a combination of both.

* Source: Fact sheet for Vanguard Diversified Bond Index Fund, The Bloomberg AusBond Composite 0+ Yr Index and the Barclays Global Aggregate ex Securitised Index.

Property basics

Australians have long had a love affair with property. According to an Australian Bureau of Statistics report*, owner-occupied properties account for more than 40 per cent of household assets. In addition, almost 20 per cent of households own rental properties and holiday homes.

While direct residential property has been the traditional form of investment for many Australians, listed property trusts or real estate investment trusts (REITs) as they are also called have also risen in favour. REITs are pooled investments with units listed on the stock exchange, which hold a basket of properties in one or more of the property sectors.

The S&P/ASX 300 A-REIT Index provides the broadest coverage of property trusts listed on the Australian share market. It currently includes stocks across the retail, diversified, office, industrial and hotel and leisure sectors.

Risk/return characteristics

Property is a long-term investment with higher risk than fixed interest investments but lower risk, historically, than shares.

Direct property potentially offers steady rental income, tax breaks via negative gearing and capital appreciation. At the same time, it has a number of drawbacks. It takes time to buy and sell: Building a diversified property portfolio is an expensive exercise, your property exposure is limited to one sector, locating and keeping good tenants can be difficult and there is always ongoing care and maintenance. There is also the risk of capital loss and lower rentals during times of oversupply.

REITs provide many of the benefits of direct property investment without all the effort. Returns from listed property can include income in the form of rent received from the underlying properties and capital growth (or loss) from changes in the value of the share price. Listed property trusts also offer tax advantages to investors in the form of tax deferred income distributions.

Income-seeking investors often compare the income yields (income as a percentage of capital value) of real estate investment trusts to ten-year bonds when assessing investments. It's important to remember that while yields are usually positive share prices can fall.

Some trusts have more stable income streams than others particularly those with quality tenants and secure lease terms in a good position.

REITs have similar risks to shares. As property trusts are listed, their share price can rise and fall in value and is subject to swings in investor confidence and other factors impacting sharemarket returns.

Individual REITs are also subject to risk, with investment quality and investment exposure varying across the sector. For example, trusts involved in development projects tend to be riskier with higher gearing levels than other sectors making them sensitive to interest rate rises.

Last decade, the REIT sector underwent considerable structural changes as the focus moved towards development, funds management and leverage opportunities, which increased the sector’s volatility level and risk profile. The sector has since realigned itself to its traditional long-term risk and return characteristics, which has restored its diversification benefits.

Accessing a diversified portfolio of REITs

Managed funds can invest in single or multiple listed property sectors. Some even include some exposure to direct property and international property securities. The main benefits of managed funds are that you can invest in properties you would not be able to access directly yourself and you can hold a diversified portfolio of properties for a relatively small initial outlay.

* Household wealth and wealth distribution in Australia, 2011-12, Australian Bureau of Statistics.

Australian shares

Investing in the sharemarket provides a way of participating in the future profits and growth of Australian and international businesses. In Australia, there are more than 2,000 companies listed on the stock exchange, representing a market capitalisation of $1.69 trillion*.

Risk/return characteristics

Shares are generally considered a high-risk and high-return investment and are suitable for longer-term investors.

Historically, Australian shares have provided long-term growth well above inflation. However, shorter-term sharemarket returns have experienced higher volatility at times.

Sharemarket investors may expect a negative return approximately once in every five years or so, which is why shares are suited to longer term investors. Time greatly reduces, but does not eliminate, the volatility in returns from shares.

Sharemarkets move in cycles, reflecting the underlying strength of the economy, political factors, industry trends and market sentiment. On any given day interest rate and inflation expectations, company profits, dividends, economic growth figures and the rise or fall of our dollar may have an impact on share prices.

Income and capital growth

While shares are primarily a growth asset, they may also provide a good source of income.

Most companies distribute a proportion of their profits in the form of dividends. Companies that pay high dividends tend to be blue chip companies like those in the banking, insurance and retail sectors. Some companies, like those in the mining sector or newer industries like biotechnology, may retain dividends to fund future research, expansion or exploration.

Actual yields may change dramatically from year to year and vary from company to company. If company profits are not growing, dividends are likely to be stable and if profits fall, a company may have to reduce dividends.

Tax benefits

Dividend imputation is the main reason Australian shares are so tax effective. Given companies have already paid tax at the company tax rate, investors can use franking credits to offset the amount of tax they pay on dividends and have any excess credits refunded. The higher the franking level the greater the benefit.

Some companies pay fully franked dividends, with the maximum imputation credit of 30 per cent (equal to the company tax rate). Other companies pay partially franked dividends where the imputation credit will vary depending on the amount of tax they have paid on their profits.

Implementing your portfolio

You can invest in the sharemarket directly or through a managed fund. One of the major benefits of a managed fund is that you can access a much wider range of investments than you can investing directly yourself. Another is that your assets are professionally managed.

Index-tracking traditional index funds and Exchange Traded Funds (ETFs) invest in all or a representation of stocks in a selected index with the aim of producing index returns, before fees. By contrast, many active Australian share funds hold between 30 and 70 stocks, out of a universe of around 200 to 300 securities depending on the index used.

*Australian Securities Exchange. End-of-month valuation, July 2015.

International shares

Investing internationally may increase your diversification and give access to industries and companies not available in Australia. After all, Australia represents around two per cent of the total world sharemarket.

Many industries are not represented or under-represented in Australia. For example, the MSCI World Index has an allocation of more than 25 per cent to the fast growing information technology and healthcare sectors. By comparison, Australia has less than eight per cent in these sectors.

The Australian market is highly concentrated with a large representation in the financial services and resource sectors. The top 10 Australian companies make up around 50 per cent of S&P/ASX 300 Index, with four out of the top five companies in the financials sector.

Improving your risk/return profile

Diversifying your portfolio internationally may help to improve your return potential and potentially lower your risk.

As each country experiences different economic growth rates, consumer sentiment and political issues, international sharemarkets may grow at different rates. Within each country there will also be industries and companies that perform better at different times. For example, the retail sector tends to perform well when interest rates are low and consumer confidence is high.

Accessing global investment opportunities

Investing in a global equity fund that tracks the MSCI World Index is one way of achieving access to many of the world's best known brands such as Apple, Microsoft, Johnson & Johnson and Nestle. These companies can be classified as truly global with customers around the world.

The MSCI World (ex Australia) Index comprises approximately 1,600 companies listed on the exchanges of 22 of the world's major developed economies.

There are a number of different international share fund types, including:

  • Country or regional funds invest in a single country, like the US, or a single region like South-East Asia.
  • Global share funds hold a diversified portfolio across world sharemarkets.
  • Specialist funds like global sector-, theme- or style- biased funds can invest in a single sector like global resources or a basket of countries like emerging markets, for example.
  • Indexed funds are designed to track a market index so they will hold a wide variety of stocks. Index funds are also available in global, country and sector types.

Top 10 companies in the MSCI World (ex Australia) Index are:

  • Apple (US)
  • Microsoft (US)
  • Exxon Mobile (US)
  • Wells Fargo (US)
  • Johnson & Johnson (US)
  • General Electric (US)
  • JP Morgan Chase (US)
  • Nestle (Switzerland)
  • Novartis (Switzerland)
  • Pfizer (US)

Risk/return characteristics

Shares are generally considered a high-risk and high-return investment and are suitable for longer-term investors.

Historically, international shares have provided long-term growth well above inflation. However, shorter-term sharemarket returns have experienced higher volatility at times.

Sharemarket investors may expect a negative return approximately once in every five years or so, which is why shares are suited to longer term investors. Time greatly reduces, but does not eliminate, the volatility in returns from shares.

Sharemarkets move in cycles, reflecting the underlying strength of the economy, political factors, industry trends and market sentiment. On any given day interest rate and inflation expectations, company profits, dividends, economic growth figures and the rise or fall of our dollar may have an impact on share prices.

Currency

International share portfolios receive their returns from two sources - the change in the value of the investment and currency returns. When the Australian dollar rises relative to overseas currencies, it has a negative performance impact for Australian investors, and vice versa.

Fully hedged funds incorporate a currency hedge to act as a buffer against local currency fluctuations. In effect, the total return is relatively unaffected by currency fluctuations, however the hedging can affect income distributions. When the Australian dollar appreciates, distributions may be higher, but a depreciating dollar can result in low or nil distributions. As the Australian dollar exchange impact has been removed, hedged investors may focus solely on international market movements.

Having said that, investors can face an opportunity cost to currency hedging. Currency exposure may add an important diversification element to overseas investing. While US dollar denominated assets may make up the largest component of an international equity portfolio, a diversified international portfolio may be exposed to more than 12 different currencies.

Some fund managers will partially hedge their portfolios based on their market outlook. Currency markets can be volatile and speculation on currency movements risky.

Sources include: MSCI World (ex Australia) Index, July 2015, S&P Dow Jones Indices.

Diversification

Diversification is the most important of all investment concepts. It simply means investing your money across a range of asset classes and securities.

You've probably heard of the term "not putting all your eggs in the one basket". A well-diversified portfolio based on an investor’s circumstances typically blends Australian and international shares, bonds, property and cash.

Why diversify?

Spreading your money across a range of investments is one of the best ways to reduce your exposure to specific market or security risk.

Investment markets tend to move in different cycles, reflecting the underlying strength of the economy, industry trends and investor sentiment. Diversifying your portfolio may help smooth out market ups and downs as returns from better performing assets help to offset those that aren't performing so well.

It's all about correlation

Correlation is a term used to explain how closely two investments are related.

As different asset classes and sectors usually perform differently, holding investments with low or negative correlations reduces overall return volatility by spreading risk across a range of investments. For example, historically, Australian fixed interest has had a low or negative correlation with Australian shares.

Implementing a diversified portfolio

You can achieve diversification in a number of ways:

  • Include exposure to different asset classes, like shares, fixed interest and property;
  • Hold a spread of investments within an asset class, like different countries, sectors and securities.
  • Invest in a diversified managed fund that provides exposure to different asset classes, such as shares, fixed interest and property.
  • Invest in a number of funds managed by different fund managers. For example, blending active with index managers.

An advantage of investing in a managed fund is that your money is pooled with other investors so you can access a much more diversified portfolio than you could yourself.

Looking beyond last year's winner

Diversification means you don't have to worry about trying to time the markets for the right time to invest. With a diversified portfolio you are always in the market.

As different asset classes typically perform differently, picking winners can be difficult. Quite often the best performing asset class or investment one year can appear as one of the worst the following year.

To see how asset class correlations work in practice, try our interactive index chart.

Investment costs and performance

Managed fund costs can add up over time and directly impact your investment returns - sometimes by as much as 2% each year.

The types of fees managed funds may charge include:

  • Entry or establishment fees.
  • Contribution fees.
  • Withdrawal fee.
  • Exit or termination fees.
  • Ongoing management costs.
  • Switching fees.
  • Adviser service fees or trailing commissions.
  • Master trust and platform fees.

Not all managed funds charge these fees, so make sure you examine the fine print and know exactly what you are paying for and how much.

Typically index funds have lower management fees than actively managed funds. For example, Vanguard's retail fees are around half the industry median. Vanguard doesn't charge entry or exit fees, contribution or switching fees (apart from the usual buy-sell spreads that apply to all transactions) and does not pay commissions to advisers.

Lower costs can translate into better performance for investors over the long term. For example, a 1% difference in total annual fees and costs (eg. 2% rather than 1%) could reduce your final return by up to 20% over a 30-year period.

As founder and former CEO of the Vanguard group John C Bogle says: "common sense tells us that performance comes and goes, but costs go on forever."

See how different fees can impact your investment returns with Vanguard's managed funds cost calculator.

Secrets of successful investors

Successful investors employ tried and true investment techniques and stick to their strategy in good and bad times. Here are our five top investment tips that have stood the test of time.

1. Diversify
Diversifying across a range of asset sectors, industries and securities reduces market risk and can improve your performance potential. Investment markets move up and down at different times. With a diversified portfolio of investments, returns from better performing investments can help offset those that underperform.

2. Invest often
Timing the markets for the best time to invest is easier said than done, which is why many investors use a dollar cost averaging strategy. With this strategy, you invest a set amount into a managed fund on a regular basis, regardless of the unit price, to average out market fluctuations over time. The great thing about this strategy is that you are always invested, so you don't miss out on potential performance by sitting on the sidelines waiting for the right time to invest.

One of the easiest ways to implement this strategy is to start a regular investment plan with a managed fund. Vanguard offers this service through BPAY®. Once you've opened your investment with $5,000 or more, you can use BPAY® to start a regular investment plan with as little as $100. You can even invest in a new fund without completing another application form.

3. Invest long term
People often get caught up with short-term stock selection, which can deliver inconsistent results. While one stock might deliver great returns one year, it is difficult to pick winning stocks every year.

When it comes to investing, it generally pays to invest long term. While sharemarket returns can fluctuate widely over shorter periods of time they tend to be less volatile over longer time periods.

4. Costs matter
Costs can take a large chunk out of your investment return. So, it's important to compare fund fees before you invest. Look at things like contribution fees, adviser commissions and management fees as these can all add up over time. Not all managed funds charge these fees, so make sure you examine the fine print and know exactly what you are paying for and how much. Some funds, like Vanguard's Investor Index Funds, have scaled management fees so investors pay a lower fee on higher amounts.

5. Less tax can mean higher returns
A fund manager's investment approach can make a big difference to the amount of tax you pay on your investment earnings and the amount of investment return you get to keep.

Turnover is one of the most important indicators of the tax efficiency of a managed fund. Turnover of a fund manager's assets reflects the level of trading activity within a fund and is usually much higher in active funds. Some fund managers can turnover their portfolios by 100% or more in a year.

Index managers, like Vanguard, who use a buy and hold strategy minimise turnover and tax. For example, Vanguard's Australian Share Index Fund has turnover of around 2%.

BPAY® is registered to BPAY Pty Ltd ABN 69 079 137 518.