What is a managed fund?

Managed funds, also known as 'mutual funds', are not as popular with investors as they used to be. With the rise of alternatives like exchange-traded funds (ETFs), listed investment trusts (LITs), and listed investment companies (LICs), many investors have forgotten about the humble old managed fund.

So, what exactly is a managed fund, and do these investment vehicles still have a place in a modern portfolio?

An introduction to managed funds

A managed fund is an investment vehicle that a fund manager looks after. Its basic structure involves a type of trust called a unit trust. The trustee (or fund manager) manages a portfolio of investments, such as ASX shares or corporate bonds, on behalf of the trust's beneficiaries. 

To become a beneficiary, you must buy shares or 'units' in the trust. The number of units you own represents a proportional interest in the trust (similar to company shares). 

Think of buying into a managed fund as pooling your capital with other investors, with a fund manager monitoring your investments and making decisions on your behalf to try to maximise returns.

A managed fund might invest in a single asset class, such as ASX shares, international shares, or corporate bonds. Or it might invest in a mix of different asset classes. It depends on the fund's objectives, strategy, and risk profile.

You can have share-only, bond-only, or a fund that will invest in just about anything it deems appropriate at any given time.

Types of managed funds

As we've just discussed, many different types of managed funds invest in various combinations of asset classes. Determining which fund is right for you will depend on your investment objectives and personal risk profile.

For example, cash funds invest in short-term fixed-income investments like bank bills and bonds. While these may be lower-returning, they are also less risky than other types of managed funds.

At the other end of the spectrum are hedge funds that invest in alternative asset classes like derivatives, private equity, and commodities. These funds can sometimes be very high-returning but are also very high-risk and unsuitable for all investors.

There are also managed funds that invest in specific types of equities. For example, some funds will only invest in Australian shares, while others will only invest in international shares. Some managed funds target shares in particular sectors of the economy, like infrastructure or property.

Then there are managed funds that invest in different asset combinations to achieve a particular investment goal or pursue a specific strategy.

For example, an income fund may invest in corporate bonds and high-quality blue-chip shares to maximise its dividend distributions. A capital growth fund may target small companies with the best long-term growth potential in emerging markets.

Advantages of a managed fund

Managed funds are among the oldest investment vehicles around, far pre-dating exchange-traded funds (ETFs). The appeal of a managed fund is relatively simple. 

Firstly, it enables investors to pool their capital with other investors to invest in assets that may otherwise be out of their financial reach, such as property, mortgage-backed securities, or corporate or government bonds. 

Secondly, it provides an easy way for investors to invest in shares or other assets without personally managing their investments. If you have money to invest but don't know anything about investing, managed funds are an easy option.

When you invest in a managed fund, you know that a financial professional is working your money for you. Instead of doing hours of research yourself, you can rely on their investing skills, knowledge, and expertise to grow your wealth.

Thirdly, some investors prefer the managed fund structure as it is relatively cheap, and it's easy to add extra funds periodically. 

Shares or units of an ETF or LIT must be bought and sold on the share market, meaning transaction fees or brokerage costs have to be paid. In contrast, managed fund units are traded off-market rather than on an exchange. 

That means you can apply for additional units in the fund directly from the fund manager. These will typically be issued after the market close at a fund-determined price. As such, you can often invest as little as $50 or $100 at a time without paying brokerage fees (although the fund manager may charge a small fee or 'spread'). This makes managed funds well suited for a dollar-cost averaging strategy. 

What are the disadvantages?

The managed fund structure does have its fair share of critics.

Expensive fees

The foremost disadvantage is the high fees charged by fund managers. Managed funds often charge far higher fees than ETFs, LITs, or listed investment companies (LICs). 

A managed fund will typically ask for a management fee of 1%, 1.5%, or even 2% per annum and may also charge an additional performance fee or establishment fee. In contrast, it's not uncommon to find index fund ETFs with a management fee of 0.1% per annum or lower. 

This is partly because a managed fund is more expensive to run than an ETF. A fund manager usually has a team of analysts and researchers monitoring the financial markets for new investment opportunities — and all these people need to be paid.

On the other hand, a passive ETF typically requires virtually no management. ETFs that track a particular index are often driven by algorithms that execute trades automatically. Whenever the composition of the ETF drifts away from its benchmark index, the algorithm executes trades to bring it back into line.

This makes many ETFs cheaper to invest in than managed funds. However, you are paying for the fund manager's expertise with a managed fund. You don't simply want to track the returns of a particular index — you want to beat them.

So, for a managed fund to be worthwhile to an investor, it has to consistently deliver a post-fee, market-beating performance each year — a feat that many managed funds struggle to accomplish.

Open-ended

Another problem with managed funds is their open-ended nature. Unlike individual companies or LICs, there is not a finite number of shares on issue with a managed fund. That means when investors buy into the fund, new units are created. When investors sell out, those units are destroyed. 

Under normal circumstances, this isn't a concern because supply and demand will not affect the fund's unit price performance for its remaining investors. But it can be a problem during a market panic or crash. 

A massive sell-off of a managed fund's units can quickly run into trouble if its underlying investments are not sufficiently liquid.

Take a property-focused managed fund as an example. If half the investors sell their units in a single day, the fund manager can't sell half a house to redeem those units. Because of this phenomenon, many managed funds retain the option to freeze withdrawals in these situations. That means you might be unable to pull your money out until the fund can balance its books.

How to invest in a managed fund

To invest in a managed fund, you need to purchase units in the fund. However, as we mentioned earlier, most managed funds aren't listed on an exchange like the ASX. If you want to buy units in a particular managed fund, you must submit an application form directly to the fund.

Also, remember that many managed funds require a minimum initial investment when you first buy their units. This might be in the range of $5,000 to $10,000.

Is there another option?

An alternative way to invest in managed funds is using the ASX mFund settlement service.¹ Because mFund uses the same CHESS electronic system as the ASX, it allows you to buy and sell units in unlisted managed funds similarly to ordinary shares.

The mFund service removes the need for lengthy application forms and makes tracking your investments in managed funds much more straightforward. But it also comes with additional brokerage fees.

Always remember that selling (or 'redeeming') your units in the fund takes longer than selling shares. Even when using the ASX mFund settlement service, a fund usually takes about ten business days to process a redemption.

This makes it essential to carefully consider your financial situation before investing in a managed fund. And make sure that the fund you invest in aligns with your investment objectives.

Don't invest in a high-risk, high-returning growth fund if you get nervous at the first sign of market volatility.

If you're considering investing in managed funds, the best thing you can do before making any investment decision is to speak to your financial advisor.

The bottom line

There is nothing wrong with the managed fund structure; many today have delivered market-beating performances for their investors. 

However, managed funds have some clear disadvantages, so picking the right one for your investment portfolio is of the utmost importance.