Posted by Scott Keefer on Jun 20th, 2008

The end of the financial year is looming and with it comes income distribution season for managed funds. The end of year will still see many of these funds making significant income distributions to unit holders. You may think that this does not make a great deal of sense given the tough share market conditions we have experienced so far this year. Unfortunately, these funds still have taxable gains that have been made throughout the year which need to be passed on to investors.

Managed funds provide two types of returns to their investors. The first is when the managed fund increases in value. This is a great way for an investor to receive their return, as there is no tax paid on this growth in unit price until they sell. This effectively defers the tax payable on this growth.

The second way that an investor receives a return is through distributions. This is a much less tax-effective way of receiving a return as the distribution is taxable. Some of this is likely to be fully franked income, probably the first 4% of a distribution in the current market environment, with the rest of the income being a distribution of ‘realised capital gains’.

What this means is that over the course of the year the managed fund has been trading some of its shares, and has made a profit on the sale of some shares, a realised capital gain, and has had to pass those capital gains on to investors to be taxed.

That is why for taxable investors and superannuation funds it is much better to receive a small income distribution and a large increase in the managed fund unit price rather than the other way around.

Even non-taxable investors (people on a 0% tax rate or superannuation funds in pension mode) should be interested in the level of the distribution, as a high level of distributions is a sign of a high level of trading within the fund – which is expensive and generally ineffective.

I scanned the web this morning looking at some of the well known managed funds managed by some of our major Australian financial institutions. Across the board you can see that it has been a difficult time for fund managers with many returns negative for the year to the end of March 2008 (as an aside the returns to the end of May are slightly better but all still in negative territory).

Unfortunately the funds are passing on taxable distributions. For instance the BT Australian Share Fund’s 1 year return as at 31^st March was made up of negative growth of 18% with 12% of distributions for the year. If we use 4% as a proxy for fully franked dividends this equates to an 8% capital gain return on which an investor will pay tax. The Colonial First State Australian Share Fund has negative growth of 23% and distributions of 12%, the AXA Australian Equity Growth fund had negative growth of 26% and distributions of 18%.

Unfortunately what this means is that if investors do not realise (in terms of the tax man) the negative growth, i.e. they continue to hold the investment through to the 30^th June, their investment will have gone backwards plus they will have some nasty tax liabilities to face in their tax returns from these funds creating an even worse performance. They won’t be able to offset the capital losses that have not yet been realised.

Another little poison in this distribution tail is that many of the capital gains that are distributed will be in relation to assets that have been held for less than 12 months and therefore the 50% capital gains tax discount does not apply with all of these gains taxable at your marginal tax rate.

This tax ineffectiveness of actively managed funds is another reason why I see that actively managed funds don’t work for investors. It is much more efficient to hold funds which trade significantly less and therefore are not realising capital gains, such as passively held investments like index funds. It is then up to the investor to decide when or if any capital gains exposure is to be realised. For some who hold these investments in superannuation they could defer this until retirement when they could organise these capital gains to be cultivated free from capital gains tax.