Chapter 02 – Why Dover advisers should recommend direct shares (and skip fund managers altogether)

Once the decision to invest in the share market has been made, there are two main avenues for doing so. The first is directly. The second is indirectly, via some sort of investment manager. These are generally referred to as ‘managed funds.

Traditionally, managed funds have been the preferred investment vehicle for most financial advisers. The main reason for this is that most financial planners were aligned with institutions who provide managed funds. Those institutions restricted their planners (either explicitly or implicitly) to only making use of managed funds – and the in-house managed funds at that.

Estimates vary, but in general over 80% of financial advisers in Australia are institutionally-aligned. The good news: 100% of Dover’s advisers are not institutionally-aligned. This creates an enormous competitive advantage for Dover advisers when it comes to investing in the share market. 

This is because Dover simply does not require that our advisers use managed funds. Indeed, as you will see below, in most cases we would prefer that managed funds were avoided. The client will be better off, and so will the adviser. 

Dover advisers are free to recommend the use of managed funds (from the approved products list) if they think that this is the best way for a particular client to access the share market. Managed funds do have some advantages, and the fact that they are commonly used by financial planners means that the appropriate use of managed funds is unlikely to see an adviser being sued for negligence for recommending them.

However, the fact that Dover does not require its advisers to recommend managed funds frees our advisers up to access the share market in a far more efficient manner. As will be shown below, it is quite easy for advisers to assist their clients to enter the share market in a way that avoids expensive fund managers. The money saved by avoiding the fund manager can be used to more appropriately remunerate the adviser (who, after all, does all the work) as well as to create an increased return for the investor.

If you follow the principles laid down in these pages, then any clients who invest in the share market will do so more productively than if they invested via a managed fund. Please note what we are saying here: we are saying the investment will be more productive. In the event of a share market downturn, the investment might still lose money. But it will not lose as much money as it would were it invested via a more expensive managed fund. This is because these pages aim to show you how to help investors minimise the cost of their share market investment. 

In order to demonstrate just how more effective this investment will be, consider the two examples below. In the first, a couple have $200,000 to invest following the sale of a business. In the second, an individual has a $500,000 inheritance. These two examples are used to show that the inefficiency of managed funds becomes more pronounced as the amount under management increases.

As these examples show, fund managers will extract tens of thousands of dollars in fees from client investments over a ten year period. This money could and should instead be paid to the adviser (who does all of the work) and/or the client (who takes all the risk).

This is why we say that all Dover advisers should be recommending that share market investments, where warranted for a particular client, should be made directly by that client.  Direct investments lead to better returns for the investor (who takes all the risk) and increased fees for the adviser (who does all the work).

Medium Investor – $200,000

Consider the following example.

Ravi and Ajay are a couple in their early fifties. They have just sold their contract cleaning business and have a lump sum of $200,000 (net of all taxes and other amounts owed) to invest. They come to see you as their adviser.

Given their other assets, the sensible use for this money is to use it to make an investment into the share market. You (the adviser) have a range of options available to you in assisting Ravi and Ajay to do this:

Let’s examine each of these options in turn.

Option 1: Invest $200,000 in the MLC Wholesale Australian Share Fund.

This is a managed fund with the following investment objective: to match the return of the S&P/ASX 200 accumulation index – before fees. For amounts less than $500,000, the investment must occur via MLC’s platform, as detailed in the link above. 

The fees for this fund are as follows:

  1. Administration fee: 0.4% per annum; plus
  2. Investment fee: 0.27% per annum.

The total fee is therefore 0.67% of the amount invested. This amounts to $1,340 per year. This is the amount that MLC will withdraw from Ravi and Ajay’s investment.

You need to add your advice fee to this cost.

Option 2. Invest $200,000 in the Vanguard Index Australian Shares Fund.

This is a managed fund with the following investment objective: to match the return of the S&P/ASX 300 accumulation index – before fees.

The fees for this fund are as follows:

  1. Buy cost of 0.1% ($200 payable upon acquisition);
  2. Sell cost of 0.1% ($200 payable upon disposal);
  3. 75% for the first $50,000 ($375 per year); plus
  4. 50% for the next $50,000 ($250 per year); plus
  5. 35% for the ($350 per year).

The acquisition fee is therefore $200, and the annual management fee is $975. When the units are disposed of, there will be a disposal fee of 0.1% (currently valued at $200).

Option 3. Invest $200,000 in Blackrock’s Ishares S&P/ASX 200 ETF.

This is an exchange-traded fund (ETF) with the following investment objective: to provide investors with the performance of an index, before fees and expenses, composed of the largest 200 securities on the ASX.

The management fees within the ETF are 0.15%. These fees are paid before the fund’s net asset valuation is calculated. On a shareholding worth $200,000 this equates to $300 per year.

Assuming that Ravi and Ajay purchase their holdings at one time via ETrade, the brokerage would be 0.11% of the trade value. This would represent $220 at the date of acquisition. If Ravi and Ajay were to purchase their shares in four smaller parcels bought regularly over time, the acquisition brokerage would remain $220.

The brokerage to eventually dispose of the shares would be the same percentage: currently valued at $220 if they sell all the shares at once, or $360 if they sell the shares in smaller parcels.

Option 4. Invest $200,000 in a portfolio of directly held shares.

Let’s assume that this portfolio will hold shares in five companies, for diversification. If the five companies were all bought at the same time ($40,000 each), the brokerage would be $220 (five times $44) if bought through ETrade. If the five companies were bought at four different points in time, the brokerage would be $84.80 at each point in time, coming to $339.20 altogether.

The brokerage to eventually dispose of the shares (at current values) would be the same: $220 if they were disposed of all at once; $339 if they were disposed of in four stages.

Summary and Discussion

Each of these four options will achieve similar investment returns before fees. The first three explicitly track either the ASX200 or the ASX300 Accumulation index (these indices are virtually the same: the ASX200 accounts for 72% of the market and the ASX300 for 74%). The fourth may vary from this, unless the shares chosen are representative of the index. For example, if the five shares chosen were the largest five shares on the ASX (by market capitalisation), then the portfolio would constitute over 23% of the market. (If the investor instead bought shares in the ten largest companies, he or she would cover almost 34% of the market).

For now, we will assume the direct portfolio is such a ‘market tracker.’

The following table summarises the costs of each of the four options:

Option Initial Cost Annual Cost
1 MLC Nil $1,340
2 Vanguard $200 $975
3 Ishares $220 $300
4 Direct Shares $339 Nil

The holding cost of the direct portfolio (option 4) can be treated as nil. While many might think that the costs within the companies whose shares are held should be factored in, it should also be remembered that the companies whose shares the investor holds directly under option 4 are the same as the companies held indirectly through any of the first three options. Accordingly, costs within those companies affect the investment return of every option equally.

But this is only the initial cost. If we assume that the index achieves an average rate of return of 5% (which is well below the long-term average), things look very different:

Option Initial Cost Annual Cost Comments Cost over ten years, assuming 5% growth per year Disposal Cost (after ten years, presuming 5% growth)
1 MLC Nil $1,340 This fee will increase if and as the investment increases by an amount equal to 0.67% of the increase in investment value. $17,697 Nil
2 Vanguard $200 $975 This fee will increase if and as the investment increases by an amount equal to 0.35% of the increase in investment value. $11,995 $325
3 Ishares $220 $300 This fee will increase if and as the investment increases by an amount equal to 0.15% of the increase in investment value. $3,962 $358
4 Direct Shares $339 Nil   Nil $339

This table is truly staggering. A modest investment of $200,000 growing at a modest growth rate of 5% leads to management fees of up to $17,697 over the next ten years.

Large Investor – $500,000

Liling is in her mid-forties. Her mother just died and she has inherited $500,000.

She comes to see you as her adviser.

Given Liling’s other assets, the sensible use for this money is to use it to make an investment into the share market. You have a range of options available to you in assisting Liling to do this:

Let’s examine each of these options in turn.

Option 1: Invest $500,000 in the MLC Wholesale Australian Share Fund.

This is a managed fund with the following investment objective: to match the return of the S&P/ASX 200 accumulation index – before fees.

The fees for this fund are as follows:

  1. Administration fee: 0.4% per annum; plus
  2. Investment fee: 0.27% per annum.

The total fee is therefore 0.67% of the amount invested. This amounts to $3,350 per year. This is the amount that MLC will withdraw from Liling’s investment.

Option 2. Invest $500,000 in the Vanguard Index Australian Shares Fund.

This is a managed fund with the following investment objective: to match the return of the S&P/ASX 300 accumulation index – before fees.

The fees for this fund are as follows:

  1. Buy cost of 0.1% ($500 payable upon acquisition);
  2. Sell cost of 0.1% ($500 payable upon disposal);
  3. 0.75% for the first $50,000 ($375 per year); plus
  4. 0.50% for the next $50,000 ($250 per year); plus
  5. 0.35% for the ($1,400 per year). 

The acquisition fee is therefore $500, and the annual management fee is $2,025. When the units are disposed of, there will be a disposal fee of 0.1% (currently valued at $500).

Option 3. Invest $500,000 in Blackrock’s ishares S&P/ASX 200 ETF.

This is an exchange-traded managed fund with the following investment objective: to provide investors with the performance of an index, before fees and expenses, composed of the largest 200 securities on the ASX.

The management fees within the ETF are 0.15%. These fees are paid before the fund’s net asset valuation is calculated. On a shareholding worth $500,000 this equates to $750 per year.

Assuming that Liling purchases her shares at one time via ETrade, the brokerage would be 0.11% of the trade value. This would represent $550 at the date of acquisition. If Liling were to purchase her shares in four smaller parcels bought regularly over time, the acquisition brokerage would remain $550.

The brokerage to eventually dispose of the shares would be the same percentage: currently valued at $550 if Liling sells all the shares either all at once or in smaller parcels.

Option 4. Invest $500,000 in a portfolio of directly held shares.

Let’s assume that this portfolio will hold shares in five companies, for diversification. If the five companies were all bought at the same time ($100,000 each), the brokerage would be $550 (five times $110) if bought through ETrade. If the five companies were bought at four different points in time, the brokerage would be $137.50 at each point in time, coming to $550 altogether.

The brokerage to eventually dispose of the shares (at current values) would be the same: $550.

Summary and Discussion

Each of these four options will achieve similar investment returns before fees. The first three explicitly track either the ASX200 or the ASX300 Accumulation index (these indices are virtually the same: the ASX200 accounts for 72% of the market and the ASX300 for 74%). The fourth may vary from this, unless the shares chosen are representative of the index. For example, if the five shares chosen were the largest five shares on the ASX (by market capitalisation), then the portfolio would constitute over 23% of the market. (If the investor instead bought shares in the ten largest companies, he or she would cover almost 34% of the market).

For now, we will assume the direct portfolio is such a ‘market tracker.’

The following table summarises the costs of each of the four options:

Option

Initial Cost

Annual Cost First Year

1 MLC Nil $3,350
2 Vanguard $500 $2,025
3 Ishares $550 $750
4 Direct Shares $550 Nil

The holding cost of the direct portfolio (option 4) can be treated as nil. While many might think that the costs within the companies whose shares are held should be factored in, it should also be remembered that the companies whose shares the investor holds directly under option 4 are the same as the companies held indirectly through any of the first three options. Accordingly, costs within those companies affect the investment return of every option equally.

In this example, the MLC option looks poor to begin with (as does the Vanguard one).

But this is only the initial cost. If we assume that the index achieves an average rate of return of 5% (which is well below the long-term average), things look very different:

Option Initial Cost Annual Cost Comments Cost over ten years, assuming 5% growth per year Disposal Cost (after ten years, presuming 5% growth)
1 MLC Nil $3,350 This fee will increase if and as the investment increases by an amount equal to 0.67% of the increase in investment value. $44,242 Nil
2 Vanguard $500 $2,025 This fee will increase if and as the investment increases by an amount equal to 0.35% of the increase in investment value. $25,862 $325
3 Ishares $550 $750 This fee will increase if and as the investment increases by an amount equal to 0.15% of the increase in investment value. $9,905 $853
4 Direct Shares $550 Nil   Nil $853

Again, this table is truly staggering. A $500,000 investment growing at a modest growth rate of 5% leads to management fees of up to $44,242 over the next ten years.

Our Basic Question – Who should get these fees – an institutional fund manager or the client’s personal adviser?

As the above examples show, using a fund manager to enter the share market can be a very expensive business – even when the fund manager simply cannot perform better than the client could achieve for himself or herself. We would like to see that expense being directed away from the fund manager and, at least in part, directed instead to the financial adviser who is doing all of the work.

Let’s now compare the first and the fourth options, from the point of view of the adviser. The two portfolios will achieve essentially the same pre-fee return. But the client with $200,000 will pay the fund manager over $17,000 in fees over the next ten years if they take that option. And the client with $500,000 will pay over $44,000.

Dover’s basic question is: why should a fund manager get these fees? If the manager is doing nothing more than buying the largest shares in the market in the proportion in which they exist in the market, which is actually achieved by running a simple computer program, why should this large fee be going to them?

The adviser is the one doing all the work. For just a little more work, the adviser could legitimately charge the client something less than either $17,700 or $44,000 over the next ten years and still be satisfied that they are adding greater value to that client than would be the case if the adviser made use of a managed fund. 

For example, suppose for Ravi and Ajay the adviser recommends MLC and proposes to charge the client $250 per quarter to meet and discuss their financial situation. This is a fee from the client to the adviser – it is in addition to the $17,700 in fees paid to the fund manager. Over the next ten years, the client will pay the adviser $10,000 in regular fees (for now we assume there is no need for advice on other elements of the financial profile). The client, therefore, will pay around $27,700 in fees to the adviser and MLC.

But, again, it is the adviser who is doing all of the work. We would much prefer to see the adviser double her own fee and encourage and assist the client to own their shares directly. The client now only pays $20,000 (and saves $7,000) but the adviser has doubled his or her revenue.

For Liling, if she is going to pay her adviser $250 per quarter for the next ten years and make use of the managed fund, the total cost becomes $54,000. In this case, the adviser could instead recommend direct shares while also tripling her fee to $30,000, while still leaving Liling well ahead.

Remember: the client takes the risk and the adviser does the work. So, the client should get the return and the adviser should get the fee.

The Dover Group