The questions that must be answered

By Mark Fryer

Choose your vehicles 2: Managed options.

While the range of managed investments can be daunting, with unit trusts, superannuation funds, listed trusts and others all competing for investors' money, they are all based on one simple idea.

That idea is pooling - bringing together lots of individual investments to create a pool of money that can be professionally managed and invested efficiently, often in areas that small investors would not have access to as individuals.

The advantages include convenience, the ability to diversify even if your investment is small, and the fact that most managed investments are very user-friendly. But before you give your money to any manager, there are some basic questions to ask.

What am I investing in?

In some ways, the most important question of all. Before worrying about who the best manager is, or how rival funds have performed, narrow the field by working out what type of investments you want your money going into, based on your tolerance for risk and the portfolio you are trying to build up.

If you are deeply conservative, for example, there's no point considering an emerging market share fund.

What's the strategy?

Read the investment statement to try to understand what the manager's strategy is. One of the major divisions is between managers who are "active" and those who are "passive". The active managers try to choose the best investments to buy, in the hope that they will perform better than the market in general. Passive managers, on the other hand, are guided by some sort of mechanical formula, following the logic that it is highly unlikely that any manager can consistently beat the market, that it is a waste of money and effort trying to do so, and that the best a fund can hope to do is follow the market.

The difference is more than philosophical; active managers will typically charge more in ongoing fees, and New Zealand-based passive funds enjoy a considerable tax advantage in that they do not pay tax on their capital gains, unlike locally-based actively managed funds. Active managers sometimes maintain that passive funds are dangerous because they will follow markets down as faithfully as they follow them up, whereas an active manager can take action if a market fall looks likely.

However there is no guarantee that even an expert manager will be able to predict a fall in time to take precautions.

How big is the fund?

Some observers say a New Zealand fund should have at least $10 million to be an attractive investment. One reason is that the more money a fund has, the more widely some of its costs can be spread, meaning lower fees and ultimately a bigger share of the profits for investors. And if a fund has been around a while and still hasn't attracted much money, you have to ask why so few investors find it appealing.

Can you switch?

The investment that's right for you today may not be right tomorrow, so check whether your prospective fund manager offers a range of investments, and whether you are allowed to switch among them without having to pay a new entry fee every time.

What's the cost?

Before you invest, be sure you understand how the manager charges, and how much those costs are. Be especially careful if you're considering a superannuation scheme (a "retail" scheme available to the public, that is, rather than one provided through the workplace).

Some superannuation products have fees which are difficult to understand and can be costly, especially if you pull out of the investment after a short time. Most other managed investments - unit trusts, group investment funds and so on - have a simpler fee structure.

First you pay an entry fee, which can go up to 6 per cent of the amount invested. The fund manager gives most of that fee back to the adviser who put you into the fund, which is why some advisers are able to offer "free" advice.

From then on, the costs of running the investment fund, including the manager's profit, are taken out of the investment pool at regular intervals. While investment management has to be paid for, those costs effectively reduce your return, so it's worth checking how much they are. Look at the investment statement to see what the "management expense ratio" (MER) is. The MER is just a way of wrapping up some of those ongoing costs into one figure, expressed as a percentage.

So if you have $100,000 in a fund with an MER of 1.5 per cent, for example, having your investments managed is costing you $1500 a year. Typically, though not always, there is no fee when you withdraw your money. If you are investing through an adviser, negotiate to see if you can get the up-front fee reduced. Or, if you're happy taking your own advice, you can use a discount brokerage, some of which offer investments with no up-front fee at all.

"Listed" investments (see "who buys, who sells," below) have a different fee structure. There are still ongoing management charges, but instead of an entry fee you'll have to pay brokerage to a sharebroker when you get into the fund, and again when you get out.

What about tax?

Most locally-based managed funds suffer a hefty tax disadvantage because they have to pay tax on their capital gains. Do-it-yourself investors, on the other hand, generally don't have to pay tax on such gains. Some managed investments - for example, passive funds and UK listed trusts - aren't taxed on those gains, which means they can pass on a greater share of their profits to investors.

If you are investing for the longer term, that difference can really add up. Before you put money into any fund, check how it is taxed and find out whether there are any lower-tax alternatives available. Who buys, who sells?

Most managed investments on offer locally are "unlisted", which is another way of saying they are not traded on the sharemarket. To put money into an unlisted fund, you buy units from the fund manager and to get money out you effectively sell those units back to the manager. The manager is responsible for setting the unit price, by working out how much the fund's total assets are worth, then dividing by the number of units on issue. Those unit prices are published regularly, and many managers offer 0800 numbers so you can easily check what your investment is worth.

Some other funds are "listed", meaning you buy shares rather than units. Those shares are bought and sold on the sharemarket, via a broker. Without a manager setting a price, shares in listed funds are worth whatever the market says they are worth. Because of the sharemarket connection, the value of shares in a listed fund may be more volatile than units in an unlisted investment.

However, listed funds may also be cheaper to run - because the manager doesn't face the cost of buying and selling units - and some of the listed alternatives locally have tax advantages.

Who's the manager?

There is no law that says big fund managers will produce better results than small ones, but there can be a peace of mind benefit in going with a manager who is a long-established household name.

Big managers are also more likely to have a large stable of funds, which you may be able to switch to cheaply if your investment goals change in future.

How does it rate?

Assessing managed funds is not easy for the non-expert. To help sort the good from the bad, two organisations regularly assess the competing managers and their individual funds, and give them a "star rating" of up to five stars for the best funds or managers. Ratings from Morningstar are published in the Weekend Herald every week and are also available on the company's web site (www.fpgresearch.co.nz). The other rating firm, IPAC, also uses a five-star scale. Its rankings can be found on its web site (www.ipac.co.nz). The two firm's assessments won't necessarily match, since IPAC makes its decisions on the basis of past performance, while Morningstar also considers more subjective issues, such as the strength of the investment management team.