Brian Gaynor 's Opinion

Investment columnist for the NZ Herald

Brian Gaynor: Slice of the PIE versus the whole portfolio

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Photo / Thinkstock
Photo / Thinkstock

I was involved in a very interesting debate at this week's Institute of Financial Advisers conference. The issue was whether managed funds or PIEs (portfolio investment entities) are a better investment vehicle than direct funds or IMAs (individual managed accounts).

In PIEs, money is aggregated into a pool and managed as a single portfolio. Investors own units in PIEs, rather than shares in individual companies.

In IMAs, investors have their own separate portfolios and realise cash by either selling shares or accessing cash from their portfolio.

The direct funds referred to in this column are IMAs managed by brokers, banks and financial advisers rather than portfolios managed by individuals on their own behalf.

Before October 2007, there was a clear bias towards direct funds, which was reinforced by the landmark 1990s Rangatira court case.

Rangatira Ltd, which will celebrate its 75th anniversary in December, was assessed for tax by the Inland Revenue Department on gains from share sales between 1983 and 1990.

The IRD argued that these shares were acquired for the purpose of resale and were taxable.

The case, which went to the Court of Appeal and Privy Council, reconfirmed the practice under which actively managed pooled funds or unit trusts were subject to a capital gains tax on share gains.

This was because they were in the business of making a profit rather than holding investments for the long term.

This capital gains tax was assessed, at up to 33 per cent, on realised and unrealised profits as far as a fund's unit price was concerned. This meant managed funds were at a clear disadvantage compared with direct funds, which were not subject to a capital gains tax.

All that changed on October 1, 2007 with the introduction of PIEs.

PIE funds are exempt from capital gains tax on many New Zealand and Australian sharemarket investments.

This means PIEs can buy and sell Australasian shares without fear of a capital gains tax, whereas direct funds could be subject to such a tax if the IRD decides, as it did in the Rangatira case, that the original investments were made for the purpose of resale.

The IRD does not usually take this stance but it is always a possibility if there is excessive trading in an IMA portfolio.

PIEs also have an advantage in tax on income.

Income for individuals in the top income tax bracket is taxed at 28 per cent in a PIE, against 33 per cent in an IMA portfolio.

As well, PIEs save time and money on tax returns because all the tax is accounted for within the PIEs, whereas all income received in an IMA portfolio has to be included in an individual's tax return.

The next issue is the legal status of the two investment styles.

PIEs are governed by a prospectus system which requires the manager to clearly set out the fund's investment mandate, its fees, risk profile and other items relating to it.

PIEs also have a trustee and are subject to direct oversight by the Financial Markets Authority.

The newly formed FMA has taken a proactive approach on breaches of prospectus requirements, particularly in relation to failed finance companies.

Direct funds do not have the protection of a prospectus system, although a legal contract is usually signed by the investor and the manager.

These contracts may or may not contain many of the requirements and information included in a prospectus.

Hubbard Management Funds' problems show the importance of investors knowing whether they are investing in managed funds or direct funds.

If the legal structure is uncertain, as it is with Allan Hubbard's entities, investors may have to wait a long time before their money is returned.

But it is important to note that Hubbard's funds management business is an exception - most PIEs and IMAs have clear legal structures.

The other big difference between active PIEs and IMAs is the way they are managed.

PIEs are usually managed by an investment team that does not have many client relationship responsibilities and can spend most of its time on the management of these PIEs.

Direct funds are usually managed by individuals who have client relationship responsibilities.

Investment decisions regarding IMAs are often based on model portfolios prepared by a company's investment division.

A single portfolio is much easier to manage than multiple portfolios, particularly in volatile market conditions.

IMA managers can produce good results if they closely follow a well-constructed model portfolio.

Direct funds have a clear advantage over managed funds in transparency or the content of a portfolio.

Investors in direct funds have full sight of their portfolio, whereas many New Zealand PIE managers are reluctant to disclose the up-to-date content and weightings of their portfolios.

Managed funds have a clear advantage in terms of the ability to compare performances. The FundSource figures on page B13 of today's Business Herald enable investors to compare the performance of PIEs, whereas there is no way of comparing the performance of IMAs with each other.

Individuals have more control over the content of an IMA portfolio, although most managed funds' providers have several different PIEs from which to choose.

Supporters of direct funds also argue that they are more liquid, so investors can obtain cash more quickly than they can from PIEs.

This is not always true, as shown by Hubbard Management Funds. Most of Hubbard's IMA portfolios were invested in illiquid investments that have been difficult to realise.

In general, IMAs are no more liquid than well-run PIEs.

Managed funds usually take a more active approach to corporate governance issues, particularly voting at company meetings.

This is because there is one manager and one proxy form for each PIE, whereas there may be numerous managers and hundreds of proxy forms for each company meeting as far as direct funds are concerned.

Finally there is the alignment of interests and fees.

PIE funds should have a policy under which their managers must invest in the fund rather than have their own individual portfolios.

Under this policy, the interests of the manager and the client are totally aligned, something that cannot be achieved in direct funds.

Fees, which are always a major issue, are difficult to compare because disclosure is often incomplete.

One of the positive features of managed funds is that the investment returns are usually quoted after all fees whereas the performance of direct funds are often reported on a before fees basis.

There is usually little difference between PIE and IMA fees as long as all fees are taken into account, including any additional costs associated with tax reporting in relation to direct funds.

But in the final analysis most investors want their investment portfolio to produce a high return without taking too much risk.

With this in mind it is easy to compare the performances of PIE funds with each other, or direct funds with PIEs, through FundSource and Morningstar data.

However, it is important that the comparisons are made on an after- fees basis.

Brian Gaynor is an executive director of Milford Asset Management, and has a bias for PIE funds because he manages the Milford Active Growth and the Milford Active Growth KiwiSaver PIE funds.

- NZ Herald

Brian Gaynor

Investment columnist for the NZ Herald

Brian Gaynor has written a weekly investment column for the Weekend Herald since April 1997. He has a particular passion for the NZX and its regulation. He has experienced - and suffered through - the non-regulated period prior to the establishment of the Securities Commission in 1978 and the Commission’s weak stewardship until it was replaced by the FMA in 2011. He is also a Portfolio Manager at Milford Asset Management.

Read more by Brian Gaynor

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