Managed funds provide two types of returns to their investors.  The first is that 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.

But investors want the completely opposite outcome - it's one of the reasons so many investors are disappointed with the take-home returns from what looked like a very strong initial return in their managed fund.

Moreover, 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.

Scott Francis has written three Eureka Report articles which have included a discussion of the breakdown of returns within the major managed funds in Australia.  It is clear from the data within all three studies that the actively managed funds are passing on much higher levels of capital gains to their investors which has some serious tax consequences.  Take a look at the three articles to get a historical perspective.

29^th August 2007 - Big-name funds disappoint

15^th February 2007 - Funds' Disappearing Act

2^nd August 2006 - Planners' Money Drain

Scott Keefer also wrote a more recent blog on the 14^th of April providing some more up to date anecdotal evidence - No tax from managed funds this financial year? - think again

Another question to pose is why do unit prices always fall on the date that distributions are recorded as being made to investors?

Up until the time that the distribution has been recorded, the value of the gains received from income and capital gains are reflected in the unit price of the fund to reflect the full value of the investments that the fund holds.  Once these gains have been distributed to clients they are no longer assets within the fund but rather assets of the individual unit holders to which they have been paid.

Investors basically have two options when receiving these distributions - reinvest them back into the fund and in doing so buy more units or receive the distribution as cash to use for other investments or disposable income.

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How do we apply this?

We recommend passive or index style funds which do not trade nearly as much as actively managed funds.  Therefore the income distributions are much more modest and therefore much more tax effective for clients.

We also generally recommend to clients that they receive income distributions as cash.  Firstly for the psychological benefits of seeing the income payments being made into cash accounts and secondly it provides the opportunity to use that cash to invest in other areas or to rebalance a portfolio without having to sell down other growth assets.

For smaller investors we may be more inclined to recommend reinvestment into the fund.