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:
Residential, such as home units, villas and
houses
Commercial, such as office buildings
Retail, such as shopping centres and
individual shops
Industrial, such as warehouses, factories and
technology parks
Tourism, such as hotels, theme parks and
holiday resorts
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.
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.
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.
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.
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.
Appropriateness for You
International share funds are
a means of providing you with both income and capital growth. Furthermore the
added diversification that these investments bring into your portfolio will
reduce the impact of fluctuations in the Australian share market thus smoothing
out your returns over a period of time.
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.
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.
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.
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.
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.
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.
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.
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.
In this type of income stream
investment, the investment risk is undertaken by the provider of the pension, as
an indexed level of income is guaranteed to you. Your risks are limited to the
failure of the insurance company providing the pension, or by your personal
expenses increasing at a level that is greater than the level that the pension
is indexed to.
You should be aware that even
though complying pensions are currently exempt from the Centrelink assets test,
there is no guarantee that this will always be the case, as changes in
regulations and legislation could result in the current exemption being removed.
If this were to happen you would no longer be entitled to receive Centrelink
benefits.
Accessibility and Recommended
Investment Time Frame
This pension can only be
commuted (cashed in) during its first six months. After that it must be retained
until the income stream ceases, at which point all of the invested capital will
be exhausted.
Tax Effectiveness
Your complying superannuation
pension is particularly tax effective as a portion of the income that you
receive will be tax free, with the balance attracting the 15% tax rebate
referred to in the taxation section.
