Smart Investing Magazine

Smart Investing Winter 2008: Ten years on: Indexing strikes a chord | Vanguard news... Page 1 of 9 Smart Investing™ Winter 2008: Ten years on: Indexing strikes a chord CONTENTS Editor's letter Bear market survival tips Ten Years on: Indexing strikes a chord Take a bird's eye view Funds in cut and thrust risk tax bills Fast facts Editor's letter By Robin Bowerman The challenges are clear enough: when markets are volatile and uncertain it is hardly surprising that inertia takes hold. The emotional pendulum swings strongly to the defensive zone. The issue then becomes one of timing - with investors waiting for that ever-elusive signal that it is safe to re-enter the market. In this issue of Smart Investing we have provided a market volatility chart that helps provide a broader context for today's conditions. Markets today are providing a classic tug-of-war between short-term emotions and our long-term rational selves. The opportunities are perhaps less obvious - apart from the fact that a lot of quality assets are now considerably cheaper than they were 12 months ago. To take advantage of the opportunities requires a rational and practical way to invest that keeps risk within your comfort zone. The use of dollar-cost averaging fits the bill here. No-one knows whether markets will fall further, go sideways or start to recover. But by investing regularly over time in amounts you are comfortable with you mitigate many if not all of the risks of getting the timing wrong. Accepting that it is virtually impossible to time markets and applying a disciplined time-based approach to investing is an effective way of putting the emotional drivers to one side. As we head into a new tax year it is obvious that many investors have been keeping their powder dry and holding money in cash funds. For people with selfmanaged super funds the build-up of cash at this time of year may almost be an annual event. But as our performance chart on page 9 shows cash returns - while reassuringly secure in the short term - over the longterm have historically dramatically underperformed growth assets. So the question that has to be answered is what needs to happen to trigger the shift from cash to longerterm growth assets? If the answer to that is unclear then dollar cost averaging may be a technique worth considering. The single most important decision any investor makes is what asset allocation to set. Once you have decided on the asset allocation levels that suit your goals and risk profile it becomes a question of how you implement it across the market segments. That is where index funds are powerful implementation tools - arguably more so in difficult markets because buying the index or the market segment removes two key risks - the security specific risk that you get from buying a particular share and the risk that an active manager may make a bad judgement call and underperform the market. That still leaves market risk which is more than enough for most investors. Top Bear market survival tips Some tips to help you manage your investments during a market downturn. 1. Diversify Hold a mix of shares, property, bonds and cash investments tailored to your objectives, time horizon, tolerance for risk, and financial situation. Investing in index funds provides broad diversification for investors as they buy-and-hold all or a representative share of the stocks in an index. 2. Invest often http://www.vanguard.com.au/Personal_Investors/Vanguard_news/Smart_Investing_m... 16/02/2009 Smart Investing Winter 2008: Ten years on: Indexing strikes a chord | Vanguard news... Page 2 of 9 By using a "dollar-cost averaging" technique, where you invest a fixed amount in a particular investment at regular intervals, you can help build your investment over time. You can start a regular investment plan with as little as $100 by using BPAY®. 3. Make shifts gradually (if necessary) If a Bear market has convinced you that your tolerance for the volatility of shares is less than you thought, or if you're simply concerned, you may want to sell down to the point where you're not losing sleep over your sharemarket holdings. To reduce the risk that your emotions may be overriding a sound plan, resist the urge to make a drastic change. Consider a limit of no more than 15 percentage points in adjustments to your allocations. 4. Consider the tax consequences of selling Many investors swore off stocks after the 1973-1974 OPEC oil embargo sent shock waves through the market, leading to a massive sell down of their equity holdings. Not only did these investors miss out on the market's eventual rally, but they may have incurred capital gains taxes in doing so. Abandoning your shares or fixed interest position in response to a market downturn could result in a nasty tax surprise. 5. Tune out noise Ever felt dazed by the volume of facts, opinions, and statistics about the markets and investing? You're not alone. Investors are bombarded by larger amounts of information every day. More information can be a good thing, but it can also create a senseless urgency to act. Remember: you're most likely investing to achieve a long-term goal, not to avoid a short-term loss. Successful investors can tune out the noise and focus on their long-term goals. To put the current market volatility into perspective, Vanguard has produced a market volatility chart which maps Bear markets over the past 30 years. It shows when declines have occurred and how long it has taken the market to recover. You can view this chart below. We have not taken your circumstances into account when preparing this publication so it may not be applicable to your circumstances. You should consider your circumstances and our Product Disclosure Statement (PDS) before making any investment decision. Past performance is not an indication of future performance. Top Ten Years On: Indexing strikes a chord For common sense investors, the simplicity, low costs and tax effectiveness of indexing is music to their ears. By Susan Hely The wise men of indexing John C. Bogle, 79, is the founder of The Vanguard Group, Inc., and President of Vanguard's Bogle Financial Markets Research Center. He created Vanguard in 1974 and served as Chairman and Chief Executive Officer until 1996 and Senior Chairman until 2000. He is also a best selling author of various investment publications including Common Sense on Mutual Funds and more recently the Little Book of Common Sense Investing. Dr. Burton G. Malkiel, the Chemical Bank Chairman's Professor of Economics at Princeton University, is the author of the widely acclaimed investment book, A Random Walk Down Wall Street. The book has played an important role in encouraging the use of "index funds" by institutional and individual investors. The revised 9th edition of the book was published in 2007. His latest book From Wall Street to the Great Wall outlines investment strategies to exploit the growth of China. Jeremy Duffield is the Managing Director and founder of Vanguard Investments Australia Ltd, which serves as Vanguard's Asia Pacific headquarters. Jeremy joined The Vanguard Group in the United States in 1980 as Assistant to the Chief Executive Officer, John C. Bogle, after working in Economic Research for the Federal Reserve Bank of Richmond, Virginia. He then served Vanguard as Senior Vice President of Planning and Development until moving back to Australia in 1996. Eric Smith is Chief Investment Officer of Vanguard Investments Australia Ltd. Eric joined Vanguard in 1996 and was a key contributor to Vanguard's early growth in Australia. Eric is primarily focused on Vanguard's investment management strategy and implementation, the continued development of Vanguard's highly rated index investment process and an expanding range of new products and tailored investment solutions to a growing list of Australian and international clients. Dr Burton Malkiel Malkiel developed his random walk approach to investing 35 years ago. His theory suggests that markets are relatively efficient and so buying index funds (or a representation of the whole market) is going to outperform active funds in most cases. http://www.vanguard.com.au/Personal_Investors/Vanguard_news/Smart_Investing_m... 16/02/2009 Smart Investing Winter 2008: Ten years on: Indexing strikes a chord | Vanguard news... Page 3 of 9 Dr Burton Malkiel says telling investors that they can't beat the sharemarket over time is a bit like telling a six year old that Santa doesn't exist. People are optimistic that they can pick the right fund with outstanding performance. The problem is that there are over 10,000 managed funds on Morningstar's Australian database and how do you pick the right one? In 1973 Malkiel wrote A Random Walk Down Wall Street about how to navigate through the turbulence on Wall Street. The book went on to become an investment classic with over one million copies sold. Now in its ninth edition, Malkiel, an economics professor at Princeton University in the US, argues that shares are priced so efficiently that no professional can exploit temporarily mispriced shares with any consistency. Instead investors are better off in a broadly diversified portfolio of shares that make up an index because it will match the performance of a portfolio carefully chosen by specialist managers. "Sure. There will be a Warren Buffet or several over the next few years but the problem is you don't know who they are going to be. It's like looking for a needle in a haystack and I say buy the haystack," Malkiel told investors at recent Australian seminars held by Vanguard Investments. One of Malkiel's four timeless rules for individual investors is the folly of trying to time the market. He says people typically make terrible timing decisions. "I've never known anyone to time the market consistently. Don't think you are smart enough to know when to sell. It takes two correct decisions: when to get out and when to get back in." What history has shown is that investors typically sell nearer to the bottom and buy back in nearer to the top. "If you focus on how tough the market is and talk yourself into selling, you could miss out on the next market rally that comes along." Malkiel says investors also need to keep their investment costs low. In the US funds with the lowest costs typically outperformed funds with the highest costs from the end of 1994 to March 2008. "If you can get the market return at a cheaper price, you will do better than most of the other investors." Another rule is to drip feed your money into investments to take advantage of dollar cost averaging. Also at the end of each year, take the time to rebalance your portfolio to make sure it matches your risk tolerance. Resoundingly he believes that index funds should form the core of an investor's portfolio because they are low cost, diversified and closely track the benchmark. What should investors do about sharemarket volatility? Malkiel says volatility is just part of the share market's makeup. Each time after the share market fell sharply, it recovered and went on to reach record levels. In fact, if you had invested $10,000 in the Australian share market in 1978 and stayed invested throughout the eight share market declines, you would have earned an average of 14.7% per annum, amounting to $589,794. "Investors who have stayed the course were very handsomely rewarded in the long run," says Malkiel. Malkiel also told investors that the sub prime crisis is going to take a lot of time to unravel as US house prices have to fall further. He said that investors have to expect single digit returns going forward. John (Jack) Bogle Bogle continues to campaign for a better deal for investors. Jack Bogle is the die-hard champion of the individual investor who set up Vanguard in 1975 and the first retail index fund in 1977. Vanguard now manages $1.4 trillion for 22 million investors. Bogle is energetic and sprightly at 79. Now retired from Vanguard he remains an out-spoken critic of his industry's high fees and aggressive advertising. His useful work for investors has won him much praise, including being named one of the four investment giants of the 20th century by Fortune magazine. He spoke to Smart Investing from his office in Valley Forge, Pennsylvania. How does the sub prime crisis compare to other financial crises you have seen in your career? "This credit crisis is more stubborn than most of the nine Bear markets I have witnessed, two with falls of more than 50%." He says the others didn't have the widespread rot in the financial system that has come about from a long period of easy credit given to people who shouldn't have been lent money because they didn't have enough income, jobs or assets to pay it back, hence the term ninja loans. What can investors learn about this downturn? "Investors have to relearn the fundamentals of investing all the time. You have to get yourself into a position where you don't have to do anything. You can't get frustrated by market down-turns because they are part of the investment cycle," says Bogle who advocates investors buy-and-hold a diversified exposure to businesses at a very low cost through an index fund. The key to surviving a share market fall is not attempting to time the market and try to pick the best time to sell and buy. "You grit your teeth and hold on. There are always bumps in the road. You wouldn't get such good returns in the good times if there wasn't risk." What are your tips for Australians investors? http://www.vanguard.com.au/Personal_Investors/Vanguard_news/Smart_Investing_m... 16/02/2009 Smart Investing Winter 2008: Ten years on: Indexing strikes a chord | Vanguard news... Page 4 of 9 Bogle believes the share part of an investor's portfolio should include a diversification of shares across Australian, US and international. "The trick question is how much of your portfolio do you have in bonds?" says Bogle. "The right level of bonds is like an anchor to windward that serves to protect you a little bit from letting emotions take over." He says bonds have a rate of return that some investments such as commodities don't have. When you are young you should have a large proportion in shares and a small amount in bonds but as you age, the amount in bonds should grow because you have less time to recoup your losses and you have to rely on income. His rule of thumb is that you should hold 10 years less your age in bonds. A 50 year old would hold 40% in bonds and Bogle would hold 69% of his portfolio in bonds. Why do investors typically choose active managers? Bogle says research shows that investors are confident that they are above average investors, just as research shows that people think they are above average car drivers and above average lovers. But investors chasing exciting past performance will end up paying high fees in the vain hope that the active manager will outperform the market. The high fees eat into the performance and fail to recognise the unshakable reality of investing; that after costs the fund returns are often below the market return. "That's why institutions have so much in index funds. They understand the math that compounding costs are eroding compounding returns," says Bogle. He says if investors really like the thrill of picking active managers, then index most of the portfolio and place a small part of the portfolio in an active fund. "But I find that often people look at their active fund's performance after five years and say 'I wish I had indexed the whole lot'. Jeremy Duffield Bringing indexing to Australia has been a huge success for investors. Jeremy Duffield knew indexing would strike a chord with investors when he opened Vanguard's Australian office in 1996. He had witnessed the huge growth of index funds in the US when he joined Vanguard in 1980 to work with its founder Jack Bogle as his assistant. Then Vanguard's main fund, the Vanguard S&P 500 Index Fund, had $100 million in funds under management. When Duffield left to come back to Australia, it had grown to become the grandfather of index funds with $100 billion under management. Even though there was a fairly low level of awareness about indexing in Australia, Duffield was confident that Vanguard's index funds would appeal to common sense Australian investors. "I was inspired by the idea of the lowcost, diversified and tax effective index funds being a better way to invest for the long term," says Duffield, who is the managing director of Vanguard Investments Australia. It took almost 16 months to win the first institutional clients but over the past decade, Vanguard's growth in Australia has far exceeded Duffield's expectations. Total Australian funds have grown to $74 billion with $7.5 billion in retail indexed funds. Fourteen per cent of Australian institutional funds are now indexed. "Jeremy Duffield is three times more the entrepreneur than his mentor," says Jack Bogle, Vanguard's founder who, in comparison, had accumulated US$20 billion in the US after 11 years. Vanguard's Australian office has become the regional head office for the Asian Pacific region and employs nearly 200 people. Vanguard has championed a number of important issues for investors. It was the first fund manager in Australia to report the after tax performance of its funds and highlighted the tax efficiency that comes from the low turnover of index funds. By deferring capital gains liabilities, index funds can reduce the tax burden on investors. "Most of the investors are tax payers and many would benefit from a buy-and-hold strategy rather than incurring short-term gains or paying tax too early," says Duffield. For the year to the end of June 2007, Australia's 13 largest share funds delivered 80% of their average return as income, not capital growth compared to Vanguard's Australian Shares Index fund which earned a return made up of 21% income and 79% capital growth. If investors hold index funds in their superannuation*, they potentially can avoid paying capital gains tax when they are over 60 as they pay no tax on income from superannuation. *(only applies to certain superannuation funds) Vanguard is one of the few investment managers that does not pay a commission to financial planners for selecting their funds. Commissions go against the philosophy of being a low cost mutual fund, existing for the investor's benefit. In the US, these funds are called no-load funds and are popular with do-ityourself investors and some financial planners who are paid a fee for service. While most investment managers charge direct investors the upfront sales commission even if they by-pass a planner, Vanguard charges nothing but the investment management fee that is considerably less than the average investment management fee of 1.75% calculated by Morningstar. "Costs do matter. The only thing that is certain in investing is costs," says Duffield. http://www.vanguard.com.au/Personal_Investors/Vanguard_news/Smart_Investing_m... 16/02/2009 Smart Investing Winter 2008: Ten years on: Indexing strikes a chord | Vanguard news... Page 5 of 9 Eric Smith Actively managed funds struggle to deliver consistent returns over the medium term. Eric Smith, Vanguard's chief investment officer, has seen a number of different fads and fashions in investing over the past decade: technology; hedge funds; growth, value and high conviction funds. According to research house Morningstar some 868 new managed funds were added to its database in 2007. "Investment managers are pretty good at slicing and dicing the investment space," explains Smith, who has been responsible for overseeing Vanguard's retail index funds since they were first launched in Australia in 1998. But Smith says that investors are better off in broadly diversified investments with low turnover that help keep down the costs to investors, rather than following the latest hot fund with strong performance. "Investors don't understand how inefficient the tax structures are with many active funds." The five year returns for Vanguard's retail index funds Bear this out. Take Vanguard's Australian Listed Property Fund which invests in 36 listed property trusts across the retail, office, industrial, tourism and infrastructure sectors. Less than a quarter of the 23 Australian listed property trusts have outperformed it over the last five years. This is largely because Vanguard's fees are much lower than its competitors, at 0.9% for up to $50,000 and 0.6% for amounts between $50,001 and $100,000. "The cost is lower than all active funds in Australia, particularly if investors choose to buy the funds directly without paying a platform fee," says Smith. Vanguard's Growth Fund's performance beat 75% of the 36 growth funds on offer. The fund invests 70% in growth assets such as Australian shares, international shares, local and global property, emerging markets and international small companies while 30% is in income investments such as cash, Australian and international fixed interest. Vanguard's more aggressive High Growth Fund outperformed 88% of the 17 high growth funds. Australian share funds have often claimed to outperform index funds but Vanguard's Australian Share Fund with 300 shares in the Australian share market has outstripped 61% of the 71 Australian share funds over the past five years. Smith says that some active fund managers can have a good year or two with spectacular gains but longer term, index funds often perform better than most actively managed funds. Personal investors can look forward to an expanded selection of retail funds, says Smith. Some of the wholesale Vanguard index funds such as the Global Small Companies Fund; the Emerging Markets Shares and Global Infrastructure Funds which are available to large superannuation funds and other institutions are expected to be offered to personal investors. The Emerging Markets Shares Fund invests in around 600 companies from more than 20 countries across Asia, South America, Europe, Africa and the Middle East. Global Infrastructure invests in around 124 securities in 14 predominantly developed markets that derive a significant proportion of their income from utility and infrastructure activities. Vanguard also launched two sustainable funds in July, the Vanguard Sustainability Leaders International Shares Fund and the Vanguard Sustainability Leaders Australian Shares Fund. Vanguard has been managing sustainable investment portfolios for superannuation funds over the past six and a half years, selecting the leaders of the market sectors for the portfolio. Vanguard will continue to develop new products to suit Australian investors but they will have to conform to the key facets of Vanguard's investment approach - well diversified options across publicly traded markets that deliver longterm value to investors. Top Take a bird's eye view of your investments Investors are struggling to keep a broad long-term view or their investments. By Robin Bowerman When sharemarkets around the world are delivering the stomach-churning thrill of a roller coaster ride it is understandable that investors struggle to keep the broad, long-term view of the world in focus. Overconfidence is a real trap that investors can unwittingly fall into for no other reason than, as human beings, our brains are wired to work that way. Not that overconfidence is restricted to individuals or the field of investing. Ask yourself this simple question: how do you rate yourself as a driver? Researchers typically find that 80% of car drivers rate themselves 'above average'. After a long and strong growth market it is no surprise that overconfidence crept into the investing landscape. But why are we overconfident? http://www.vanguard.com.au/Personal_Investors/Vanguard_news/Smart_Investing_m... 16/02/2009 Smart Investing Winter 2008: Ten years on: Indexing strikes a chord | Vanguard news... Page 6 of 9 Overconfidence in our ability to predict future outcomes from past patterns is clearly a major risk in investing - and no amount of mandatory warnings about past performance not being a guide to future performance is likely to change that. Focussing on the broadest frame of reference - such as putting the recent sharemarket losses in the context of your overall wealth including super, your house, even your income helps people see short-term events in a longer-term context. Let us look at the recent sharemarket volatility and put it into an historical context - both for the Australian market and the US. A detailed analysis of Australian sharemarket moves from the end of December 1979 through to May 2008 by Vanguard's chief investment officer, Eric Smith, helps set the scene. Click to view the Australian Share Market Volatility chart Smith looked at all the daily moves that were either up or down by more than 2.5%. When it comes to the positive side of the ledger there have been 39 daily rises above 2.5% since the end of 1979. On the debit side there were 52 days that the market value (as measured by the S&P/ASX200 Index and its predecessor, the All Ordinaries Index) fell more than 2.5%. Now let's look at the past nine months from August 1, 2007. Given that the first half of 2008 has seen the steepest decline in the Australian sharemarket since 1987 it will not surprise anyone to learn that there have been 12 trading days when the market fell more than 2.5%. Easily the worst day was January 22 when the market dropped 7.05%. But when you look back at sharemarket return histories there is another fact that emerges which tends to surprise people. Big falls and big rises tend to cluster together. It happened in 1987 and it has happened again with the recent turmoil. Take the long weekend in March as a case study. On March 19 the market was up 3.9%. The next day it was down slightly more than 3%. On the next trading day after the long weekend on March 25 it was up 3.7%. These types of shifts highlight how difficult it is to try and time markets. Since August 1 last year there have been 12 days when the market has gained more than 2.5%. The best day was January 25 when it rose 5.02%. Looking at how the volatility of the last 10 months compares in the longer time frame tells us we are in a period of high volatility - 24 of the 90 days since December 31, 1979 that either rose or fell more than 2.5% have occurred since August 2007. So the market data confirms the emotional roller coaster that the markets have been on. But if you look back at the volatility for the previous three years it was historically low. For Australian shares using standard deviation, as the volatility measure the past 10 months is 16.8%. Look over five years and the measure drops to 10.2% which just underscores how low market volatility had been prior to August last year. The US market as measured by the S&P500 Index tells a similar story. After a period of lower than average volatility from 2004 to 2006 volatility increased in 2007 but when you broaden the timeframe to 1970-2007 the annualised standard deviation is 16% - 2002 being a dramatic year with the volatility measure at 26%. Extreme market conditions clearly challenge our ability to invest for the long-term. But it is worth considering that the volatility in sharemarket returns is a leading factor contributing to its higher long-run expected returns. In a market update about sharemarket volatility Vanguard's US Investment Counselling and Research group says that if the risks borne by diversified equity investors are to be rewarded, as they have been historically, then the largest portion of the payoff for that risk might reasonably be expected to follow periods of market difficulty, when the risk of loss may be perceived to be great. "Over time, risk premiums will vary with the current, as well as the expected, investment environment and lower current prices suggest higher risk premiums and higher relative future returns. While it may be very difficult to capitalise on these shifting risk premiums through tactical allocation a well thought-out strategic asset allocation can serve as a logical anchor for investors, helping to keep them from reallocating their assets in response to volatility," the research update says. One research study shows that if investors are shown market returns on a monthly basis they will typically allocate 40% to equities. However, if investors are shown market returns on an annual basis they will typically allocate about 70% of the portfolio to equities. Short-term market information can make us quite myopic about our investments potentially to our long-term detriment - an interesting challenge given the easy internet access to portfolio valuations and trading tools. To help Vanguard investors understand the long-term perspective, our updated market return index chart shows the recent volatility to the end of March. Market downturns of more than 10% since 1980 have been added along with the time it took to recover to the previous highpoint. For Australian shares there have been seven declines of more than 10% based on monthly returns - and the recovery period has ranged from as short as two months to as long as 63 months post the 1987 crash. The average recovery period is 16 months. The US sharemarket, which is such a big driver of international returns, tells a similar story with an average recovery period of 14 months. http://www.vanguard.com.au/Personal_Investors/Vanguard_news/Smart_Investing_m... 16/02/2009 Smart Investing Winter 2008: Ten years on: Indexing strikes a chord | Vanguard news... Page 7 of 9 The listed property market tells a more unusual story - in the past 28 years there has only been one decline of more than 10% before the sector was hit hard in the last quarter last year. Again you have to look back to 1987 for a comparable situation where the property trust market fell 26% and took 38 months to recover. Sharemarket investors ought to expect one negative year in five. And just as we can never know with certainty what will bring growth markets to an end, we also cannot predict what will spark the next growth cycle. Our Reserve Bank Governor, Glenn Stevens, in a broadranging speech in March on market conditions, now sees the risk pendulum having swung dramatically to the conservative side. While he is not downplaying the challenges that still lay ahead "it appears that some very high-quality assets are valued at prices that embody extremely pessimistic assumptions about returns". "Real savings are still flowing into pension funds, insurance companies and other institutional investment vehicles. This is genuine capital, seeking a productive use. But these investors appear to be taking a more cautious approach to risk, given the short-term uncertainty over asset valuations," Stevens says. Leverage and the lack of transparency around complex derivatives have compounded and clouded the recent market volatility. If there is one lesson investors can learn from the recent turmoil it is that the smart way to invest is to keep things simple and understand what you are investing in and the risks you are taking. That and looking at your investments with a broader, long-term view. Top Funds in cut and thrust risk tax bills Poor returns and a tax bill - why tax is such an important consideration in managed funds. By Simon Hoyle As if watching the value of your share funds plunge is not bad enough, some investors could be facing a particularly nasty end to the financial year. Depending on how your Australian share fund is managed, you could face a capital loss for the 2007-08 financial year and a hefty tax bill. Some managed share funds could be delivering the bad news as early as mid-July. A fund's total return for the year is made up of two components: income and growth. The growth figure represents changes in the capital value (mainly share prices) of the fund's underlying assets, while the income can be both dividends from the underlying shares, and short-term capital gains. Gains on assets held for less than 12 months are defined as "short term", and they are treated the same way as income, because you pay capital gains tax on 100% of the gains at your marginal tax rate (plus Medicare levy). However, with dividends from shares there may be franking credits attached, which alters the tax picture somewhat. However, if you hold an asset for more than 12 months you pay capital gains tax at your marginal rate (plus Medicare) on only 50% of the gain. So there are quite pronounced tax differences, depending on whether you trade assets regularly (within 12 months), or buy and hold the asset for 12 months or more. A growing number of, but by no means all, fund managers manage their portfolios with at least a casual eye on tax. This could mean, among other things, delaying the sale of a share to take advantage of the discount capital gains regime. But when markets are volatile, as they have been for the past six to eight months, managers may try to maintain their funds' returns by adopting short-term trading strategies that involve buying and selling shares as prices jump up and down. As shown in the accompanying table, produced by Vanguard Investments and based on Morningstar data, some of the country's largest share funds posted negative growth figures - that is, capital losses - during the 12 months ended December 31, 2007. The situation may be repeated at June 30, when the funds are required to report and provide tax information to investors. Click to view larger image: Top 20 Fund Managers - Income/Growth Returns to 31 December 2007 This table shows the 20 largest Australian share funds available to retail investors in Australia, although they are http://www.vanguard.com.au/Personal_Investors/Vanguard_news/Smart_Investing_m... 16/02/2009 Smart Investing Winter 2008: Ten years on: Indexing strikes a chord | Vanguard news... Page 8 of 9 wholesale funds, they are available to retail investors through wrap services, master trusts and other investment "platforms"). It shows each fund's total return (income plus growth) and then shows separately the income and growth components. This table does not include any losses that may have been sustained by funds in the six months ended June 30. But it illustrates quite effectively that in the period under review, most funds produced substantially more income than growth. But one fund, an index fund managed by Vanguard, had substantially more growth than income. Even though the fund's total return is broadly comparable with that of the other funds, its investors will find themselves in quite a different position after tax. Index funds simply seek to replicate the performance of a market index - for example, the ASX 300. They mirror or replicate the securities that make up the index. Michael Houlihan, the manager of retail products and technical services at Vanguard, says after-tax returns are not more relevant during market volatility or a protracted downturn. It is just that investors notice more acutely "when the market delivers a zero - or by June 30, possibly a negative - return". Funds may still post positive total returns, but for most "active" (that is, non-index) fund managers, "turnover is what generates these higher returns", Mr Houlihan says. "The reason managers have portfolio turnover is due to their style of management, and depending on their style, generally speaking, a high portfolio turnover, ie. the more times they are buying and selling stocks to generate returns, generally means they are holding these stocks for less than 12 months. "That means you don't get the 50% [capital gains tax] discount that applies to individuals, and therefore the more taxinefficient the portfolio can be." Problems arise for investors because managed funds are generally required to pay out to investors any realised gains they generate, in the period that they generate them. And if the gains do not qualify for the CGT discount they are in effect taxed like income in investors' hands - investors pay tax on 100% of the gains at their marginal income tax rate, plus the Medicare levy. The figures in the table suggest it is possible investors in a fund can suffer a capital loss and receive a tax bill at the same time. "Low turnover or zero turnover is usually a 'buy-and-hold' strategy," Mr Houlihan says. A buy-and-hold strategy relies on rising share prices to generate its returns - and if stocks are held for more than 12 months the capital gains tax bill is lower. Another effect of a buy-and-hold strategy is that the fund builds up unrealised gains, rather then spraying out realised gains left, right and centre. Unrealised gains can be an advantage to long-term investors. You may remain in the fund, sitting on unrealised gains until you reach a point where your marginal tax rate, and hence your capital gains tax bill, drops. Fortunately, more fund managers are being encouraged to develop tax-effective strategies and to create after-tax benchmarks against which to gauge their funds' returns. If fund managers can produce a better guide to after-tax returns, investors and super fund trustees will find it much easier to compare manager performance. Why tax considerations matter Tax implications affect when trades should be made. Pre-tax and post-tax returns can change how a fundsmanager may want to sell certain shares. Franking credits on a speci?c share are applicable onlyif it has been held for 45 days around the ex-dividenddate. Active management involving the frequent buyingand selling of shares can incur higher trading andmanagement costs than holding them long term. Thismanagement style also has signi? cant tax implications. A tax-ef?cient portfolio generally contains shares witha range of (purchase) dates and prices. This allows thesale of shares to be managed to minimise tax costs. Source: ITG This is an edited version of an article that first appeared in the Sydney Morning Herald on March 21, 2008. http://www.vanguard.com.au/Personal_Investors/Vanguard_news/Smart_Investing_m... 16/02/2009 Smart Investing Winter 2008: Ten years on: Indexing strikes a chord | Vanguard news... Page 9 of 9 Top Fast Facts What you need to know about the Vanguard® Investor Index Funds Click to view larger image : Fast Facts From as little as $5,000 you can invest in Vanguard's range of investor index funds. The funds offer low management fees, no upfront fees other than buy/sell spreads, competitive longterm performance and potential tax benefits. To start investing, download a Product Disclosure Statement or complete the online application form. Top GENERAL ADVICE WARNING Vanguard Investments Australia Ltd (ABN 72 072 881 086 / AFSL 227263 / RSE Licence L0001335) is the product issuer. We have not taken your or your clients' circumstances into account when preparing our website content so it may not be applicable to the particular situation you are considering. You should consider your and your clients' circumstances, as well as our Product Disclosure Statements (PDS), before making any investment decision or recommendation. You can access our PDS on this website or by calling us. Past performance is not indicative of future performance. © Copyright 2008 Vanguard Investments Australia Ltd Vanguard Investments Australia http://www.vanguard.com.au/Personal_Investors/Vanguard_news/Smart_Investing_m... 16/02/2009