Guest author: Kelvin from Money King NZ . Re-published with his permission.
An easy way to start investing is to put your money into funds. One problem is that there are thousands of funds out there, and so many confusing concepts surrounding them. So let’s kick the year off with a beginners guide to funds, what they invest in, where you can invest in them, and the differences between index funds, ETFs, and more! (with NZ specific examples!)
Any funds or fund managers mentioned in this article are not recommendations, and are for illustrative purposes only.
1. What is a fund?
Managed Fund, Mutual Fund, Exchange Traded Fund, Index Fund. They are all different names for funds, but they all boil down to the same thing. A fund is essentially a pool of money which gets invested into lots of assets – like shares, bonds, bank deposits, property, and commodities. Chances are you already invest in a fund – your KiwiSaver fund!
Fund Managers – Responsible for offering funds to investors and the overall management of a fund. When you invest your money into a fund, you receive units in that fund, and the fund’s manager decides where to invest your money. Some New Zealand fund managers include AMP, Kernel, Simplicity and Smartshares.
How you can make money from funds
Capital gains – The assets inside a fund (like shares and bonds) constantly go up and down in value. This will be reflected in an increase (or decrease) of a fund’s unit price, which represents how much each unit of a fund is worth. If you sell your units for a higher price than what you paid for them, you’ll make money from capital gains. If you sell your units for a lower price than what you paid for them, you’ll make a capital loss.
Dividends/Distributions – Funds may collect dividends and interest from the assets inside the fund. Some funds pay out this income regularly as distributions. Some funds don’t pay distributions (KiwiSaver funds are a good example of this) – instead any dividend/interest income is reinvested into the fund’s assets and reflected in an increase in your unit price.
Key benefits of funds
Funds allow you to pool your money together with other investors, enabling you to access a much more diversified set of investments, than you would be able to access on your own – funds can contain anything from just a few assets, to shares in thousands of companies!
Another key benefit is that you don’t have to spend time and effort finding, researching, and picking which individual shares or bonds to invest in, as your fund manager does all that work for you.
In return for those benefits, you pay a management fee to the fund manager. This is expressed as an annualised percentage of how much you have invested. For example, if you invest $10,000 into a fund, and the fund’s management fee is 0.36%, then you can expect to pay approximately $36 in management fees over a year.
The management fee is not an out of pocket fee (i.e. not something the fund manager deducts out of your account). Instead the management fee is typically calculated daily and reflected in a tiny reduction in the fund’s unit price. Some fund managers may also charge a fixed admin or membership fee (e.g. $3 per month) in addition to the fund management fee.
2. What assets are inside a fund?
A single fund can potentially invest in many assets (as many as thousands), giving you a lot of diversification by just investing in one fund. Different funds invest in different asset classes and geographies:
When you invest in shares of a company, you own a part of that company. Share (or equity) funds invest in the shares of many different companies. Shares offer some of the highest returns over the long term, but come with higher risk, generally making them most suitable as part of a longer term investment portfolio. Share funds generally fit into one of three categories:
- Market wide – Invests in a broad section of the market, usually across many industries e.g. Smartshares US 500 ETF invests in the 500 largest companies in the United States.
- Sector specific – Invests only in one industry sector e.g. Kernel NZ Commercial Property Fund invests only in commercial property REITs.
- Characteristic specific – Invests only in companies which have a particular characteristic e.g. Devon Dividend Yield Fund invests only in high dividend yielding companies, and Smartshares US Small Cap ETF invests in smaller size companies in the US.
When you invest in bonds (or fixed interest assets), you are lending your money to a government or company, and in return you’ll get paid a fixed rate of interest. Fixed Interest funds are generally suitable as a key part of a medium term investment portfolio – while the potential returns of bonds are lower than shares, bonds are much less volatile.
Examples are the Smartshares Global Aggregate Bond ETF or the Nikko AM NZ Corporate Bond Fund (which only invests in corporate bonds).
Cash (bank deposits)
Cash funds invest in bank deposits like term deposits, and are generally suited for short term investment because of their ability to protect your portfolio from volatility. There aren’t many cash funds in NZ, and they charge high fees for the low returns you get – so instead of investing in cash funds, it might be a good idea to open a savings account or term deposit directly through your bank.
Funds are not limited to shares, bonds, and cash. Here are a couple of examples of NZ funds investing in other asset classes:
- Commodities, like gold and oil. An example is the Pathfinder Commodity Plus Fund
- Physical property, like a farm or office building. An example is the Booster Private Land and Property Fund
Diversified funds invest across more than one asset class within the same fund. Examples are the Simplicity Growth Fund (investing in ~74% shares and 22% cash and bonds) and the AMP Capital Income Generator Fund (split around 50/50 between shares and bonds).
The majority of KiwiSaver funds are diversified funds, containing a different mix of shares, bonds, and cash depending on whether it’s a Growth, Balanced, or Conservative fund. For example the JUNO Growth Fund targets investing in 80% Shares and 20% Cash & Bonds, while the JUNO Conservative Fund targets only 25% in shares.
Domestic funds mostly invest only in New Zealand assets, like the shares and bonds of NZ companies. Examples are the Kernel NZ 20 Fund (investing in the 20 largest companies on the NZ sharemarket), and the Smartshares NZ Bond ETF (investing in NZ bonds). Some domestic funds also include Australian assets, like the Milford Trans-Tasman Equity Fund.
These funds invest in assets from around the world, and are handy for diversifying your portfolio outside of New Zealand, as it’s not always easy for individuals to buy shares and bonds from other countries.
- Global – Invests in assets from around the whole world. Examples are the AMP Capital All Country Global Shares Index Fund, and the Smartshares Global Aggregate Bond ETF
- Regional – Invests in a specific region or country. Examples are the Smartshares US 500 ETF (investing in the United States), Smartshares Emerging Markets ETF (investing in emerging markets e.g. China, India, Brazil, Indonesia)
Other asset characteristics
Often also labelled as responsible or ESG, ethical funds avoid investing in assets considered undesirable, such as shares in tobacco or fossil fuel companies. They might also focus their investments on assets that make a positive difference to the environment or society. Examples are the CareSaver Growth Fund, or the Smartshares Global Equities ESG ETF.
3. Investment strategy of a fund
At a high level, funds can employ one of two strategies to invest and manage your money – Active or Passive.
Actively managed funds employ a team of human fund managers to research and pick what specific assets to invest in. Their objective is to pick the assets that they think will deliver the best returns for investors. Most funds in New Zealand are actively managed – examples of fund managers using active management are ANZ, Booster, JUNO, and Milford.
Passive management (Index Funds)
Passively managed funds are commonly known as Index Funds, because they track (or follow) an index. So what is an index? I asked Dean Anderson from index fund manager Kernel for some input:
An index measures the performance of a market, or part of a market, by capturing the performance of the individual securities (in the case of an equity index, the individual company shares within the index) within the index. Taking the S&P/NZX 20 index as an example, the performance of the index represents the combined performance of the 20 companies within the index. – Dean Anderson, Founder & CEO, Kernel
Essentially an index represents a slice of the market. This could be a broad slice (like the S&P/ASX 200 representing the top 200 companies on the Aussie market), or something more narrow (like the S&P/NZX Real Estate Select Index, which only represents NZ Listed Property companies) – Dean tells me Index Provider S&P DJI manages over a 1 million indices! So how do index funds use indices?
- Firstly, Index Providers (like S&P DJI, MSCI, and FTSE) design and run indices. And according to the rules of each index, they determine each index’s constituents (e.g. the companies that belong in the index) and their weightings (what percentage of the index each constituent takes up).
- Next, Index Fund Managers (like Kernel, Smartshares, and AMP) buy a license to use an index’s data for their funds. For example, Kernel’s NZ 20 Fund takes the data of the S&P/NZX 20 Index, and invests in the same constituents and weightings.
- Lastly, having invested according to the index’s data, the Index Fund should closely replicate the performance of the index and the market it represents.
So what’s the rationale for funds to track an index? Firstly, it’s cheaper to follow an index compared to hiring active fund managers, and this is reflected in lower fund management fees for investors. Secondly, most active fund managers perform worse than the market over the long term – It’s very hard for even really smart people to consistently outperform the market!
4. Where can you invest in funds?
There are many channels in which you can invest in funds, making them a very accessible form of investment.
ETF – Exchange Traded Fund
The term ETF is commonly confused with Index Funds, but they are not the same thing! ETFs are simply funds in which you can buy and sell their units on the sharemarket (in the same way as shares in an ordinary company) – hence the name Exchange Traded. Examples are the Smartshares NZ Top 50 ETF, and Smartshares Total World ETF.
Not all Index Funds are ETFs – For example, the AMP Capital All Country Global Shares Index Fund and Vanguard Select Exclusions International Shares Index Fund both follow an index, but are not ETFs as they aren’t listed on the sharemarket.
Most but not all ETFs are Index Funds – Salt Carbon Fund (C02), and Booster Private Land and Property Fund (PLP) are examples of ETFs that are actively managed.
While you can use a sharebroker to buy an ETF off the sharemarket, in many cases you can also buy units in an ETF direct from the Fund Manager or through a Fund Platform (see below).
LIC – Listed Investment Company
I want to briefly mention Listed Investment Companies (LICs) here as they are essentially funds structured as a company. You can buy shares in LICs off the sharemarket, in the same way that you can buy units in ETF. Examples are Kingfish Ltd (KFL) and The City of London Investment Trust (TCL). While LICs are uncommon in NZ, they are much more popular in Australia.
Fund Platforms can be described as “fund supermarkets”, because they’re a one-stop shop for heaps of funds (including ETFs!) from heaps of different fund managers. They’re my favourite way to invest in funds because of their low fees, low minimum investments, and large variety of funds to pick from. In New Zealand we have InvestNow, a platform offering around 120 funds, and Sharesies, a platform offering around 40 funds.
Direct from a fund manager
In many cases it’s possible to invest in a fund directly through the fund’s manager. For example, the likes of Kernel and Simplicity currently don’t offer their funds though any Fund Platforms, instead providing their own online portals for investors to buy their funds.
5. Taxation and structure of funds
Funds have different structures which can affect what tax you need to pay on them, or even when you can make withdrawals from them.
Tax on funds
Funds generate taxable income (such as dividends, interest, foreign income), as part of their investing activity. How your tax liability is calculated, and the rate at which you are taxed at depends on what kind of fund it is:
PIE – Portfolio Investment Entity
Almost all NZ domiciled funds structured as PIEs. For PIEs, the fund’s tax liability is calculated by the fund manager, then attributed and passed onto the fund’s investors to pay. PIEs come in many flavours, the two you’ll almost always come across are:
- Listed PIE – ETFs are always listed PIEs (because they’re listed on the sharemarket) and are taxed at a fixed rate of 28%.
- Multi-rate PIE (MRP) – Most other PIE funds you’ll come across are MRPs. These are taxed at your Prescribed Investor Rate (PIR).
PIEs are generally seen as tax friendly as PIE tax rates can be lower than your marginal tax rate (e.g. a maximum of 28% vs 33%), and you usually don’t have to include your PIE income in a tax return.
KiwiSaver funds are just a special type of PIE fund where your KiwiSaver contributions get invested. The main difference between a KiwiSaver fund and ordinary PIE fund are the restrictions on when you can withdraw money from the fund. See the below table for scenarios of when you can withdraw money from a KiwiSaver fund (source: Kōura KiwiSaver)
FIF – Foreign Investment Fund
FIFs are overseas domiciled funds. Popular examples are the two Vanguard International Shares Index Funds found on InvestNow, and any ETFs you buy through Hatch. You must use the FIF tax rules to calculate your tax liability on these funds. In general:
- Under $50,000 invested in FIFs: Tax is payable on any distribution/dividend income at your marginal tax rate
- $50,000 or more: Your tax liability is calculated using either the Fair Dividend Rate (FDR) or Cumulative Value (CV) methods.
You generally need to file a tax return to declare your income from FIFs, making them less convenient than PIEs.
A fund is an investment scheme where many investors pool their money together to be invested in assets like shares, bonds, property, or commodities. I like funds as investing in them gives you instant diversification across potentially hundreds or thousands of assets, and they save you from having to do research on what individual assets to invest in. They’re suitable for everyone – from complete beginners, to experienced investors.
Fund managers employ different strategies to invest your money. Kiwis are increasingly favouring passive management (Index Funds), as they begin to realise most actively managed funds perform worse, but still charge higher fees. Just remember, Index Funds and ETFs are not the same thing – ETFs are simply funds you can buy off the sharemarket, although you can also invest in them through other platforms like InvestNow and Sharesies.
Now that you hopefully know a little bit more about investing in funds, the best time to get started is now! Sign up to an investment service provider and get investing. Or check out my Funds page for more articles on funds.
This content has been adapted from the original MoneyKing article.