Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 79

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
June 30, 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 28, 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

 

Leave a Comment:

RELATED ARTICLES

A guide to tax-deferred distributions

banner

Most viewed in recent weeks

16 ASX stocks to buy and hold forever, updated

This time last year, I highlighted 16 ASX stocks that investors could own indefinitely. One year on, I look at whether there should be any changes to the list of stocks as well as which companies are worth buying now. 

UniSuper’s boss flags a potential correction ahead

The CIO of Australia’s fourth largest super fund by assets, John Pearce, suggests the odds favour a flat year for markets, with the possibility of a correction of 10% or more. However, he’ll use any dip as a buying opportunity.

2025-26 super thresholds – key changes and implications

The ABS recently released figures which are used to determine key superannuation rates and thresholds that will apply from 1 July 2025. This outlines the rates and thresholds that are changing and those that aren’t.  

Is Gen X ready for retirement?

With the arrival of the new year, the first members of ‘Generation X’ turned 60, marking the start of the MTV generation’s collective journey towards retirement. Are Gen Xers and our retirement system ready for the transition?

Why the $5.4 trillion wealth transfer is a generational tragedy

The intergenerational wealth transfer, largely driven by a housing boom, exacerbates economic inequality, stifles productivity, and impedes social mobility. Solutions lie in addressing the housing problem, not taxing wealth.

What Warren Buffett isn’t saying speaks volumes

Warren Buffett's annual shareholder letter has been fixture for avid investors for decades. In his latest letter, Buffett is reticent on many key topics, but his actions rather than words are sending clear signals to investors.

Latest Updates

Investing

Designing a life, with money to spare

Are you living your life by default or by design? It strikes me that many people are doing the former and living according to others’ expectations of them, leading to poor choices including with their finances.

Investment strategies

A closer look at defensive assets for turbulent times

After the recent market slump, it's a good time to brush up on the defensive asset classes – what they are, why hold them, and how they can both deliver on your goals and increase the reliability of your desired outcomes.

Financial planning

Are lifetime income streams the answer or just the easy way out?

Lately, there's been a push by Government for lifetime income streams as a solution to retirement income challenges. We run the numbers on these products to see whether they deliver on what they promise.

Shares

Is it time to buy the Big Four banks?

The stellar run of the major ASX banks last year left many investors scratching their heads. After a recent share price pullback, has value emerged in these banks, or is it best to steer clear of them?

Investment strategies

The useful role that subordinated debt can play in your portfolio

If you’re struggling to replace the hybrid exposure in your portfolio, you’re not alone. Subordinated debt is an option, and here is a guide on what it is and how it can fit into your investment mix.

Shares

Europe is back and small caps there offer significant opportunities

Trump’s moves on tariffs, defence, and Ukraine, have awoken European Governments after a decade of lethargy. European small cap manager, Alantra Asset Management, says it could herald a new era for the continent.

Shares

Lessons from the rise and fall of founder-led companies

Founder-led companies often attract investors due to leaders' personal stakes and long-term vision. But founder presence alone does not guarantee success, and the challenge is to identify which ones will succeed in the long term.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.