Property 

Many Australian investors have an emotional attachment to property investment because of its tangible nature and that in the 1970’s and 1980’s property returns were high. It is also important to remember that inflation rates were extremely high during this period. Lower inflation rates in the 1990’s have resulted in much lower investment returns being achieved from property. Nevertheless, most investment portfolios should have some exposure to property investment.

There are five main areas of property investment:

Whilst in theory it is possible to directly invest in all of the above, in practice very few people have the capital resources to achieve even a moderate level of diversification from direct property investment. For this reason a number of alternatives to direct property investments have been developed (for example, property securities funds, listed property trusts and property investment companies) to allow a more balanced investment portfolio.

Property is often regarded as a risk free investment because property markets are fragmented and prices are not determined every day. In reality there are moderate risks involved because the value of a property cannot be known until it has been sold. In addition, problems with tenants can impact negatively upon rental returns. Perhaps the biggest risk associated with direct property investment is its lack of liquidity, as any buyer of property needs to have access to significant funds.

Property has historically provided a good hedge against inflation because property prices tend to rise in a trend, which corresponds with inflation. However, in times of lower inflation and rising unemployment, property returns will be moderate. In fact in times of recession, property prices will tend to fall.

Some tax benefits can be achieved through depreciation of the building and of plant and equipment within it. Expenses incurred to maintain the property are tax deductible. There are also the indexing advantages on capital gains, which reduce the amount of capital gain that is taxable.  

Back to top

 
Property Securities Funds

Property securities funds generally do not own property directly, but rather hold property trusts and property companies that are listed on the Australian Stock Exchange as their underlying investments. There are many different types of listed property trusts and companies with some focusing on, for example, retail properties (Westfield Property Trust), some operating in particular geographical areas (Capital Property Trust) and others being quite diversified (General Property Trust).

Risks and Returns

It is important to remember that the underlying investments in property securities funds are trusts and companies that are listed on the Australian Stock Exchange. This means that they will to some extent follow the trends of the Australian stock market. Historically, listed property trusts have shown themselves to be less volatile than other sectors of the stock market. Listed property trust values are also effected by the level of interest rates, as investors often buy listed property trusts for the income that they produce. This means that when interest rates go down, listed property trusts go up in value and vice versa.

By investing in property securities funds it is possible to have far more diversification and therefore less risk than by investing directly in listed property trusts or companies. In general, property securities funds produce higher levels of income and lower levels of capital growth than do sharemarket funds and their overall level of return will tend to be lower than sharemarket funds.

Accessibility and Recommended Investment Time Frame

Most fund managers will process withdrawals within five working days, however they usually have the discretion to delay withdrawals for up to thirty days.

The recommended minimum investment time frame is four years.

Tax Effectiveness

Part of the income that is received from property securities funds is likely to be tax free or tax deferred due to depreciation allowances that are received for depreciation on plant and equipment within buildings as well as depreciation on the buildings themselves. (Please see the taxation section for further details.)

As the level of capital growth is likely to be below the rate of inflation, it is likely that there will be no capital gains tax on the eventual sale of property securities funds.  

Back to top

Shares

When you buy shares, you buy a proportion of an existing business. Sharemarket investors may receive income in the form of dividends and capital growth over the longer term as company profits increase.

Deciding which companies in which to invest requires extensive knowledge not only of individual companies but also of financial markets and the factors that may impact upon a company’s profitability and share price. Furthermore, in order to achieve a properly diversified portfolio, very large amounts of money would be required. For this reason, many people prefer to invest in equity (or share) trusts rather than investing directly in the stockmarket. This approach allows them to participate in a large, well diversified and professionally managed portfolio of shares and thus reduces risk.

Shares are the most volatile asset sector as share prices can change from moment to moment. Share prices are influenced by real events, which relate either to the company, the industry in which the company operates, or general economic conditions. In addition, share prices are influenced by people’s perceptions of how present and future events may impact upon individual companies.

As a trade-off for the potentially greater returns, shares also have a higher level of short term risk - on any particular day you may or may not get the price you expect.

The income earned from Australian shares is amongst the most tax effective available, due to dividend imputation. This means that where an Australian company pays dividends to its shareholders from profits, which have already been taxed, the shareholder receives a personal tax credit equal to the amount of tax which the company has already paid. There are also indexing advantages on capital gains, which reduce the amount of capital gain that is taxable.  

Back to top

Australian Share Funds

These are also known as equity funds or imputation funds. Their underlying investments are shares listed on the Australian Stock Exchange. The funds that we recommend generally prefer to buy shares in “blue chip” companies, that is, larger and well known companies whose shares are constantly in demand. Examples would be Telstra, National Australia Bank, AMP, Coles Myer and so on. Some smaller companies may also be included, however the definition of a smaller company is one with a market capitalisation of at least $100 million.

Risks and Returns

Sharemarket investments are generally seen as risky and volatile, however this is more the case in the short term rather than over the longer term when shares have generally been the best performing of all of the asset classes. The key to sharemarket investment is to buy quality and to hold the shares or share funds over the longer term. If this strategy is followed, then even allowing for the occasional major correction in the share market, the longer term benefits will be substantial.

One of the major benefits of holding sharemarket investments is that over a period of time company profits will rise resulting in an increase in the level of dividend income that is received by investors. This increase in company earnings is the major factor determining future share prices and therefore it is likely that the value of shares will increase over time.

Nevertheless, it must always be remembered that the greater the proportion of shares held in a portfolio, the greater will be the level of risk, especially in the short term.

Accessibility and Recommended Investment Time Frame

Most fund managers will process withdrawals within five working days, however they usually have the discretion to delay withdrawals for up to thirty days.

The recommended minimum investment time frame is five years.

Tax Effectiveness

Investing in Australian shares is the most tax effective of all the asset classes. This is because dividend imputation (please see the taxation section) allows the income from Australian shares to be received tax free by many investors. Even investors in the top tax bracket only have to pay tax at the rate of 12.5% on the income that they receive from companies paying the full rate of Australian company tax.

Capital gains tax is likely to be payable on capital profits made by investing in Australian share funds, however the impact of capital gains tax is reduced by inflation indexing which means only the capital gains above the rate of inflation will be taxed.

International

As Australia represents only a very small proportion of the international economy it is prudent to have some diversification away from the Australian economy. International diversification will provide exposure to companies and whole industries that do not operate within Australia. In addition, international investments will provide some diversification away from Australia’s domestic business cycle.

International investments are available in shares, fixed interest and property. However income earned from international investments is not as tax efficient, as tax may often need to be paid on all of the income, even though there is a small allowance for foreign tax credits.

International investments also carry an additional risk, that of currency fluctuations. If our dollar rises, overseas investments fall in value and losses occur. On the other hand, if our dollar falls, overseas investments go up in value and capital profits are made. Whilst it is possible to insure against adverse currency movements by hedging, the cost of hedging may reduce returns if our currency does not rise.  

Back to top

International Share Funds

As the Australian share market represents less than 2% of the world’s sharemarket capitalisation, it is logical to include some exposure to international shares. Another reason is that there are many major corporations that are not represented on the Australian Stock Exchange such as Microsoft, Ford and Sony.

The international share funds that we prefer to recommend are of the diversified global type. This means that their share portfolios are spread across the world’s major share markets and are not restricted to any particular country or market segment.  

Risks and Returns

Apart from the normal risks associated with sharemarket investments (as indicated in the Australian sharemarket section), international share funds carry an additional risk associated with currency fluctuations. When our dollar rises in value against other currencies, investors in international funds may see the value of their investments fall. However, when our dollar falls in value, investors in international share funds benefit. Astute currency management techniques can minimise this type of risk, but this can be at the expense of reduced returns.

Even though investors in international share funds have generally seen their investments outperform most other investment sectors over the last fifteen years, these investments probably carry the highest risk within your portfolio, especially in the shorter term.

Some international funds invest only in specific countries or regions such as Japan or the USA, and as a result may from time to time produce very high levels of performance, however we do not recommend these sector funds due to the higher risks associated with them.

Accessibility and Recommended Investment Time Frame

Most fund managers will process withdrawals within five working days, however they usually have the discretion to delay withdrawals for up to thirty days.

The recommended minimum investment time frame is six years.

Tax Effectiveness

Because dividend imputation only applies to Australian companies, the income received from international share funds is limited in tax effectiveness to foreign tax credits received for tax paid to overseas governments.

Capital gains tax may be payable on capital profits made by investing in international share funds, however the impact of capital gains tax is reduced by inflation indexing which means only the capital gains above the rate of inflation will be taxed.

Since the advent of the Foreign Investment Funds legislation, international funds are required to pay out as income all capital gains made during the financial year. This has resulted in international share funds becoming predominantly income producing investments.

 Back to top

Cash

You should always keep some cash readily accessible for emergencies and flexibility.

Cash may be kept in an ordinary bank, building society or credit union account, a cash management trust, or a money market investment account. Cash management and money market accounts offer the advantages of pooling funds together to invest the large amounts necessary to participate in the professional short term money market. This results in higher interest rates than the more traditional savings accounts.

Cash is the most secure type of investment because whilst interest rates may vary, the value of the capital amount invested will not.

Security of capital is dependent upon the quality of the financial institution with which funds are placed and how it invests its deposits. Even though the risks are usually very low, the trade-off for the security of cash is that historically it has offered lower returns than other investment sectors in the medium to longer term.

Cash does not offer any tax advantages because all income is fully taxable. Also, cash provides no capital growth.  

Back to top

 Cash Based Investments

A number of different investments are represented by this category including bank and similar accounts as well as cash management and money market accounts. The underlying investments are a combination of cash, overnight and short term money market securities, treasury notes and bank bills.

Risks and Returns

Cash type accounts are the safest of all investments in that the capital values can only fall due to withdrawals and / or fees. The only other way that capital can be lost is in the unlikely event of the failure of the financial institution to honour withdrawal and whilst this is possible, in reality it is most unlikely. Due to the combination of security and virtual immediate access to funds, these investments produce the lowest rates of return.

Accessibility and Recommended Investment Time Frame

These investments are known as on call funds because monies in these accounts are available on demand, either over the counter, teller machine or by cheque. For this reason there is no minimum time frame over which on call investments should be held.

Tax Effectiveness

As the return from cash based investments is purely in the form of interest, there is no tax effectiveness as all of the interest earned (less fees) is taxable income.

 Back to top

Fixed Interest

Fixed interest investments are loans to governments, government authorities, banks, other financial institutions and companies. The issuer of a loan will pay a rate of interest, which is specified when the loan is first arranged with a time frame set for the loan to be repaid at a specified date in the future. These maturity dates can vary from a few months to many years.

Fixed interest is a very secure form of investment because the interest payable and the amount to be repaid upon maturity is known in advance.

On a retail level where bonds and fixed interest investments are usually held until they mature, risk is usually low. However, professional investors tend to trade extensively and sell bonds before reaching maturity. This means that it is possible for bonds to produce capital gains as well as capital losses. Capital gains are usually made in a falling interest rate environment, whilst capital losses are usually made when interest rates rise. In bond and capital stable funds, which trade bonds, risk will be moderate.

Fixed interest investments may include the purchasing and trading of bonds as well as direct investments using term deposits, debentures and term certain annuities.

The interest income from a fixed interest investment is usually fully taxable. Any capital gains are also fully taxable. Fixed interest investments generally do not provide protection against inflation.

Back to top

Australian Fixed Interest Funds

These comprise mortgage funds, term deposits and debentures.

Mortgage Funds

These funds borrow money from investors and lend them out to borrowers. They are called mortgage funds because the borrowings are secured by mortgages over property. Mortgage funds will generally only lend up to 66% of the property value and will only go above this level if mortgage insurance is provided. Mortgage funds will also hold bank deposit and short term money market investments to provide liquidity so that redemptions can be paid.

Well managed mortgage funds will loan money out to a number of different borrowers at a mixture of different interest rates and for different periods of time. This is different to solicitor’s first mortgages where your money may be loaned to one borrower only.

Risks and Returns

The main risk with this type of investment is that the borrower will default through not being able to pay either the interest on the loan or to repay capital when required. This risk is reduced to some extent by the borrowing limitations mentioned above and the use of mortgage insurance. Nevertheless, an optimistic valuation of the property providing the security for the loan can result in failure to recover all monies owed in the event of a default.

Another risk associated with this type of investment is that of a mismatch between the term of the loans to borrowers and the level of accessibility afforded to investors. This risk is reduced by ensuring that adequate cash reserves are held within the fund and by structuring the loans within the fund so that they have progressive maturity dates. Many mortgage funds impose exit fees to ensure that these funds are not used by investors who are likely to require their money within a short period of time.

Because of their large size and mix of loans, the mortgage funds provided by the major financial institutions that we recommend have a relatively low level of risk compared to solicitor’s mortgages and share market investments. It is unlikely that their capital values will vary and at the same time they should produce a level of income that is one to two percent higher than cash investments.

Accessibility and Recommended Investment Time Frame

Many mortgage funds have exit fees to discourage short term investment. Nevertheless, most fund managers will process withdrawals within five working days, however they usually have the discretion to delay withdrawals for up to thirty days or more in some circumstances.

The recommended minimum investment time frame is two years.

Tax Effectiveness

All of the income from a mortgage trust is interest and is therefore fully taxable. This means that mortgage funds provide no tax effectiveness.  

Back to top

 Term Deposits and Debentures

Term deposits and debentures are loan securities whereby you receive a fixed rate of interest for a fixed term at the end of which you will receive your capital back in its entirety. Term deposits are usually offered by banks, building societies, credit unions and other similar financial institutions. Debentures are usually offered by finance companies.

Risks and Returns

Term deposits provided by banks and debentures provided by finance companies owned by a major bank, for example, Esanda (ANZ), AGC (Westpac) and CBFC (Commonwealth) are highly secure, thus the likelihood of you losing capital or interest is quite remote. Due to their high levels of security, these investments provide only moderate levels of returns, however it is possible to receive a higher interest rate if you invest for longer terms.

Accessibility and Recommended Investment Time Frame

Generally speaking, these investments cannot be accessed prior to their maturity dates. However in some circumstances, the financial institutions involved may be willing to redeem your investment prior to maturity, which may result in you forfeiting part of your capital and / or interest by way of penalty. The debentures offered by the major bank owned finance companies are traded by stockbrokers and can therefore be sold at any time. If these debentures are sold before maturity the result may be either a capital gain or capital loss depending upon prevailing interest rates.

The investment time frame is the term to maturity that is chosen. It is therefore important to ensure that if these monies are required for some other purpose, then investments should be chosen with appropriate maturity dates. When term deposits and debentures are used, we recommend that the capital be split so that the investments mature at different times.

Tax Effectiveness  

All of the income from term deposits and debentures is interest and is therefore fully taxable. This means that these investments provide no tax effectiveness.

 Back to top

Diversified Capital Stable Funds

These diversified funds have underlying investments that cover the main asset classes of property, shares, interest and cash. A capital stable fund will typically hold approximately 75% of its assets in cash and fixed interest, with perhaps 20% in shares (usually Australian shares) and about 5% in property. It is important to realise that these proportions are not fixed and that the fund manager has the discretion to adjust the underlying asset allocation according to market and economic conditions. Nevertheless, capital stable funds will rarely have less than 75% of their assets in cash and fixed interest.

Risks and Returns

Capital stable funds are a relatively secure investment because of their low exposure to shares. Because there will usually be some exposure to the sharemarket it is likely that capital stable funds will be effected by significant sharemarket movements (both up and down). Due to their high exposure to bonds, capital stable funds are likely to make capital gains when interest rates are falling and capital losses when interest rates are rising.

The actual performance of a capital stable fund will be dependent upon the skill of the manager and the particular strategies that are followed. It is our policy to recommend capital stable funds that have different investment strategies and thus different levels of exposure to the bond and share markets. The returns from capital stable funds will be primarily oriented towards income, however some capital gains are also likely to be made over time.

Accessibility and Recommended Investment Time Frame

Most fund managers will process withdrawals within five working days, however they usually have the discretion to delay withdrawals for up to thirty days.

The recommended minimum investment time frame is three years.

Tax Effectiveness

Because capital stable funds have some exposure to Australian shares and listed property trusts they are more tax effective than pure interest or bond investments. We would estimate that perhaps 20% of the income would be of a tax effective nature. Because the level of capital gains made by these funds is likely to be similar to or below the rate of inflation, the tax on the capital gains made is likely to be minimal.

Back to top

 Diversified Balanced Funds

Balanced funds are similar in concept to capital stable funds and are in fact almost a mirror image of them. Diversified balanced funds may have up to 60% of their underlying assets in shares and will have a much higher exposure to international investments than capital stable funds. Property exposure may also be as high as 15%, thus leaving a balance of maybe 25% spread over cash and interest. Once again the manager has the discretion to adjust the underlying asset allocations.

Risks and Returns

Because they have a much higher exposure to the sharemarket, these funds have a higher level of risk attached to them than do capital stable funds, but are also likely to produce higher returns. By way of example, if a balanced fund had a 50% exposure to the stockmarket and the stockmarket fell in value by 30%, then the balanced fund would fall in value by approximately 15%. Conversely, if the stockmarket rose 30%, the balanced fund would rise by 15%. We would expect these funds to provide you with somewhat higher levels of capital growth as compared to income.

Accessibility and Recommended Investment Time Frame

Most fund managers will process withdrawals within five working days, however they usually have the discretion to delay withdrawals for up to thirty days.

The recommended minimum investment time frame is four years.

Tax Effectiveness

Balanced funds should be significantly more tax effective than capital stable funds due to their higher levels of exposure to Australian shares and listed property trusts. This will provide you with additional imputation credits and depreciation allowances. In fact the only type of investment that is likely to be more tax effective is that of Australian share funds.

It is likely that these funds will produce a level of capital growth that is above the rate of inflation and therefore that component of the growth will be subject to capital gains tax.

 Back to top

Allocated Pension Funds

Risks and Returns

The risks and returns from an allocated pension depend upon the underlying investments.

Accessibility and Recommended Investment Time Frame

As the allocated pension is contained within a master fund structure, the accessibility lies in the first instance with the underling investment funds which will normally process withdrawals within five working days, however they usually have the discretion to delay withdrawals for up to thirty days. In the second instance, accessibility lies with the manager of the master fund, which will process your withdrawal once it has received your money from the underlying investment fund. Because allocated pension funds are governed by superannuation legislation, changes to this legislation may restrict your ability to withdraw lump sums in the future.

Even though at present there is no legislative restriction to withdrawing lump sums from allocated pension funds, our recommendation is that you view this investment as a means of providing you with a lifetime income stream.

Tax Effectiveness

As mentioned in the taxation section, allocated pensions are an extremely tax effective investment structure which can pay you significant amounts of tax free income each year.  

Back to top

Contact us:  enquiries@directadvisers.com.au

Back to Top