Updated Dec, 2020

The problem with pooled funds

What is a pooled fund?

A pooled fund is simply a fund where investors’ money is combined and invested by a fund manager. Essentially anything other than individual assets will be in pooled funds – all your well-known managed funds, ETFs, and LICs – both actively managed and index-tracking funds – are pooled. Pooling is an easy way to diversify into hundreds or even thousands of securities in a single investment.

How pooling affects capital gains

Unfortunately, since the entire fund is a single pool of assets, if there are more units sold than purchased, the fund will have to sell some assets, and this triggers capital gains for all investors of the fund. So even if you don’t sell any units, you still realise gains.

Something to note is that this does not occur with ETFs due to their unique structure. Instead, capital gains are deferred until you sell your ETF shares yourself.

Here are some links if you’re interested in understanding the ETF structure further, but all you need to know is that with ETFs when other people in the fund sell units, you don’t realise gains. Those gains are delayed until you eventually sell your units.

How ETFs are created and redeemed and why it matters – Vanguard
Tax and ETFs: 5 ways ETFs can achieve better tax outcomes for clients – Vanguard
The tax advantages of ETFs – VanEck
Taxing the advantages of ETFs – Morningstar

Important note: when the underlying fund sells assets (e.g. rebalancing, or when stocks fall out of the index), you will still realise those capital gains in both ETF and non-ETF pooled funds. What this article is talking about is whether you realise gains when other investors sell their units.

In plain English, pooled funds (with the exception of ETFs) pay tax at the fund level and therefore are taxed gradually in small amounts each year, whereas, with ETFs, you don’t realise those gains until you actually sell.

Generally, you want to delay your gains for as long as possible so that additional money can be earning money and compounding for potentially another 30 years or more. Additionally, you’re likely to be on a lower marginal tax rate in retirement meaning less tax would be payable.

Examples

One example is during the coronavirus market downturn VGAD (the ETF) had no mid-year distribution (due to currency hedging), yet the managed fund version had a distribution due to other investors selling their units. This is even despite the two funds having the same base fund because they’re two different pools of money and are managed according to the fund structure.

Here are a couple of threads where people are complaining about the managed fund version of Vanguard’s funds which are pooled (as opposed to the equivalent ETFs which were not).

Excessively high Vanguard fund distributions – Whirlpool Forums
Rant: The wholesale fund for VGS was so tax inefficient this past FY – AusFinance

Vanguard’s diversified funds are affected by this

It’s worth noting that for both the ETF and the managed fund version of Vanguard’s all-in-one funds, the 7 funds held within them are managed funds and not ETFs. So, while VDHG itself is an ETF, since all the funds within it are managed funds instead of ETFs, they suffer from this tax inefficiency. That is not to say that it is worth discarding VDHG based on this reason alone – an all-in-one fund is likely still the best option for most people, but the fact is there is some tax inefficiency in VDHG.

Interestingly, DHHF (VDHG’s about-to-be competitor) does not suffer from this problem since the funds held within them are all ETFs.

How it affects your super

Pooled funds in super pay tax along the way just as they do outside super, and while it’s taxed at a lower tax rate in super than outside super, it’s still taxed (15% for short term capital gains and 10% for long term capital gains).

However, in super once you meet a ‘condition of release’ and move funds to pension phase (i.e. when of retirement age), money pulled from super is tax-free and therefore if you instead held ETF’s in super and built-up those capital gains instead using pooled funds that realise gains along the way, all those embedded capital gains don’t need to ever be paid – provided you don’t need to sell when converting to pension phase.

Take a moment to think about that – those capital gains you accrued for potentially decades during accumulation don’t ever need to be paid. So, in super, not only do pooled funds miss out on earnings of delayed tax the same as outside super, but in super it misses out on effectively having your capital gains tax bill wiped entirely.

Most super funds are pooled. Including SunSuper’s passively managed Index funds which are regularly mentioned on investing forums as the go-to passive investing option for passive investors due to their very low fees for indexing options.

But wait, there is more.

These gains from the pooling, while not insignificant, don’t make up the majority of your total capital gains. What if there is a way to wipe the majority of your capital gains from decades of capital growth?

Capital gains tax of pooled funds: outside vs. inside super

As explained above, in pooled funds both inside and outside super, when the fund sells assets (due to investors owning the units selling), the whole pool must realise capital gains, even for individuals that did not sell any of their units. However, there’s still a difference between pooled funds inside and outside super due to the fact that outside super the units are taxed individually while in super the fund itself pays all of the tax.

This means that with pooled funds outside super, most of the capital gains are still paid by the individual. These are payable when you sell (but are lower by the amount of capital gains you have had to pay along the way as a result of others selling).

This is as opposed to pooled funds in super (which is essentially all super funds that aren’t direct investment options or wrap accounts), where all capital gains are paid by the fund and there are is no more to pay. As a result, you pay no capital gains tax when switching from pooled super funds (because it has already been taken out).

Tax provisioning in pooled super funds

To avoid the problem of capital gains building up in pooled super funds and being unfairly distributed, capital gains are provisioned. Provisioning means that if there is $100m in assets in a fund and it grew by $10m, members’ balances will total only $108.5m with the other $1.5m showing as segregated and available to pay any tax liability of members redeeming (selling) their units in that pool.

This $1.5m is an accounting record, so it is still sitting there in the pool of funds earning returns and those returns will be attributed to members, but the $1.5m that has been provisioned does not show as being attributed to the members. This is why you can switch funds in super without paying any capital gains (it has already been accounted for).

Here’s the important bit — as mentioned above, when you reach the age where you convert your super to an account-based pension (where zero tax is paid from then on), converting from a pooled fund is considered a redemption (selling and rebuying) and you are effectively paying out capital gains from decades of superannuation earnings (which have been provisioned). This is in contrast to individually taxed investments in super (and which allow in-specie transfer to an account-based pension), where all your decades of capital gains would never need to be paid. Yes, you read that right.

What can you do about it?

The simplest answer is to use an SMSF and buy ETF’s in the SMSF. Unfortunately, the cost of running an SMSF is so high that for anyone who isn’t likely to have substantial balances by retirement, the cost of running the SMSF will often outweigh the savings.

The next best option is to use a direct investment option that meets both of the following requirements.

  1. Allows investing in ETFs directly, which results in being individually taxed; and
  2. Allows converting to pension phase without the need to sell down and realise gains.

This article from etfwatch lists a number of super funds which offer direct investment options that allow you to invest in ETFs.
Which super funds allow you to invest in ETFs & LICs? – ETF Watch

These should all take care of the first requirement. Although you will need to check the second requirement – that they also support the transfer to pension without realising gains. Most if not all funds do this but it’s not something you want to make a mistake with, so be sure to double-check.

We’ll go through some of these in more detail, but there are some commonalities among direct investment options.

First and foremost, additional costs.

  1. An additional fixed cost of $180-$395 p.a. (depending on the fund manager) for using their direct investment option and, other than HostPlus & AusSuper, their regular management fee is also partly based on your balance. For instance, Legal Super is 0.29% which would be a no-go for me.
  2. Brokerage is payable and slightly on the high side.
  3. The ETF’s own management fees are payable.

Due to these costs, it appears to be better to use something cheaper such as SunSuper’s low-cost index funds for balances under about $300,000 to avoid the fact that fixed costs are a higher proportion on smaller balances which eat away at your compounding. However, at a certain point, the improved capital gains tax treatment outweighs these costs, at least in super funds with little or no admin fees tied to your balance.

Besides the higher fixed costs, there is a requirement in all these direct investment options to hold at least 20% of your assets (with a fixed minimum of $2,000-$10,000 depending on the fund manager) outside the direct investment options. This appears to be required by all funds that offer a direct investment option. While I haven’t checked all providers, the HostPlus PDS says that in pension phase, the minimum withdrawal comes from this 20% pool, and I imagine their ongoing fees and insurance premiums and any other costs come from this pool.

The HostPlus PDS says that –

Should your other investment options fall below their required amounts, you will be required to transfer cash from your Choiceplus account. This may require us to sell some of your Choiceplus shares or ETFs and LICs or break a term deposit. We will make every endeavour to contact you prior to selling any of your holdings in Choiceplus.

It makes sense that they would want a portion available in their pooled funds which are easily accessible to use for paying fees, insurance, as well as an income stream when in pension phase so that they can avoid trading shares in your direct options without the owner’s permission except as a last resort. In fact, HostPlus ChoicePlus requires 1.5x the minimum pension amount to be available in their pooled options to draw from which means at age 60 (4% pension minimum), you would need 1.5x that amount. Although with a 20% minimum in pooled options you have to wonder if it is also to ensure the pooled funds are being supported.

You also need to check their ETF options. Some of them are a little restrictive. For instance, Cbus self-managed doesn’t appear to offer many ETFs, including missing VGS, although they offer the SPDR equivalent WXOZ which has an MER of 0.40, which is close enough, although coupled with their 0.15% admin fee (on top of their fixed fees), the total cost doesn’t seem appealing.

Some direct investment options

HostPlus ChoicePlus

  • Allows you to purchase ETFs directly, making it individually taxed.
  • Allows you to transfer your ChoicePlus held ETFs from your super to your pension account without the need to sell down and realise gains.
  • They have the lowest fees with fixed costs of $180 p.a. for the direct investment option on top of the regular admin fee of $78 p.a.
    Unlike most other direct investment options, there’s no percent-of-assets fee, so once you reach an amount of assets worth using this direct option, your costs as a percentage of assets fall as your balance grows.
  • Brokerage fees also apply. As well as the ETF’s own management fees.
  • As with all other options we looked at, you are required to retain 20% of your assets (with a minimum of $2,000) outside Choice Plus in their pooled options. QSuper was an exception at 15%.
  • An important aspect to be aware of is whether there are low-cost index options in their pooled funds for the remaining 20%, and HostPlus does have low-cost index options for Australian, international, and international currency-hedged funds.
  • As with some (but not all) direct investment options, there is a limit on how much you can invest in any single security. With ChoicePus the max 20% in any single security. Although that’s not too difficult to solve by using a combination of VAS/IOZ/STW for the Australian index, and VGS/VESG/WXOZ/VGAD for the international developed markets index, and VGE for emerging markets. It should also be noted that it is 20% across your combined balance in their direct investment option and outside their direct investment option, therefore you could have one of their low-cost indexes outside ChoicePlus and 4 funds inside.

AustralianSuper member direct

  • Allows you to purchase ETFs directly, making it individually taxed.
  • Allows you to transfer your member direct ETFs from your super to your pension account without the need to sell down and realise gains.
  • Their fees are higher than ChoicePlus, currently $395 p.a. for the direct investment option on top of the other admin fee of $78 p.a. The higher fixed fee affects lower balances.
  • Brokerage fees also apply. As well as the ETF’s own management fees.
  • As with all other options we looked at, you are required to retain 20% of your assets (with a minimum of $5,000) outside the member direct option in their pooled options.
  • Unlike HostPlus, there aren’t low-cost index options in their pooled funds for the remaining 20%, except for their index-balanced option which has a substantial helping of defensive assets (cash/bonds).
  • The one advantage I can see for AustralianSuper member direct over ChoicePlus is that there’s no limit on how much you can have in any of these broad market index-tracking ETFs: VAS, VGS, VGAD. Although there’s a 30% cap on VGE which seems reasonable, and for some reason a 30% cap on bond funds (VAF/IAF/VGB), but you can just use a couple of those. There’s also a 30% max on each of VTS/VEU, but you can pair up with IVV/IVE to make up 100%

QSuper self invest

  • Allows you to purchase ETFs directly, making it individually taxed.
  • Allows you to transfer your member direct ETFs from your super to your pension account without the need to sell down and realise gains.
  • Their fees are higher than both ChoicePlus and AustralianSuper member direct, currently $299 p.a. for the direct investment option (which includes other admin fees) + 0.16% of balance, but those cap out at $900 ($562.5K balance). The percentage-of-assets fee makes it less attractive than the above two options, but there are other advantages.
  • Brokerage fees also apply and are more expensive than the previous options. ETF’s own management fees obviously also still apply.
  • Unlike all the other options which require 20% of your assets outside the direct investment option in their pooled options, with QSuper it’s only 15%.
  • For the remaining 15%, there are low-cost index options in their pooled funds for Australian and international shares which are currency-hedged, but no unhedged international shares. Although that’s not really an issue since you can just hold those in your ETFs anyway.
  • Another advantage is that unlike ChoicePlus, there’s no maximum 20% limit on any individual ETF, so you don’t have to mess around splitting your ETFs into multiple funds to get exposure to an international or Australian index. Additionally, they also offer VDHG.

Cost comparisons

To make a comparison, I need to use some assumptions, so please keep in mind that these figures may not be the same as for you.

In the following table, I’m using the following assumptions:

  • Brokerage every 2 months for purchases below $5,000
  • A portfolio of ETFs with a management expense ratio of 0.20%
  • The total cost for varying amounts is for the portion in the direct investment option and excludes the portion required outside in pooled funds besides fixed fees.

Fund Direct investment fee Brokerage cost Other fund admin fees Total cost for $100k Total cost for $200k Total cost for $300k Total cost for $500k Total cost for $1m
HostPlus ChoicePlus $180 p.a. up to 10k: $19.95 $78 p.a. $578 (0.58%) $778 (0.39%) $978 (0.33%) $1,378 (0.28%) $2,378 (0.24%)
AustralianSuper member direct $395 p.a. up to 5k: $15.00 $117 p.a. $802 (0.80%) $1,002 (0.50%) $1,202 (0.40%) $1,602 (0.32%) $2,602 (0.26%)
QSuper self invest $299 p.a. + 0.16% of balance up to $900 up to 10k: $29.50 $0 $836 (0.84%) $1,196 (0.60%) $1,556 (0.52%) $2,276 (0.46%) $3,376 (0.34%)
Pooled options for comparison purposes
SunSuper
$0 $0 $78 p.a + 0.10% of balance up to $800 $298 (0.30%) $518 (0.26%) $738 (0.25%) $1,178 (0.24%) $2,078 (0.21%)
HostPlus
$0 $0 $78 p.a $132 (0.13%) $186 (0.09%) $240 (0.08%) $348 (0.07%) $618 (0.06%)

** In the last 2 rows, I’ve added SunSuper and HostPlus pooled options as a comparison using the asset allocation as per Ma15’s whirlpool thread Recreating Vanguard diversified funds at SunSuper where the investment fee is 0.12% and for HostPlus I will use a similar allocation of 40% IFM Australian Shares (0.03%), 20% international index hedged (0.07%), 40% international index unhedged (0.07%) for a total investment fee of 0.054%

Show calculations

Conclusion

There are significant saving to be had by using direct investment options due to having decades of capital gains tax wiped upon conversion to pension in those options, however the current offerings have high fixed costs which cost more than those savings at lower balances. Going by a rule of thumb to require a total cost (including everything) of no more than about 0.35%, it looks like using HostPlus there is a crossover point around $300,000 where it becomes cost-effective to use their direct options, but other providers require higher super balances and AusSuper looks to be around $400,000 and others even higher since HostPlus and AusSuper appear to be the cheapest options at the moment.

Up to the crossing point, low cost pooled index options (SunSuper and HostPlus) appear to make more sense.

Many people are eagerly awaiting Vanguard’s plan to move into super in Australia, which is planned for mid-2021. If they make it similar to Vanguard Personal Investor which is 0.20% up to $600 and free brokerage on their own ETFs they will provide some great competition and may change the super landscape.

** Please note that as I learn more, I plan to update this article, so if you have any information that I can include for others (and that can be explained to someone with little or no prior understanding of this), please hit the contact button at the top right and let me know.

** I first read about this issue here: AustralianSuper member direct – PropertyChat. When I initially read it, I only understood that it was about tax inefficiency but not what the actual problem was. This prompted me to ask Kyle Frost who helped me understand it, but it still took time to sink in and grasp, so, once I understood it I decided to turn this into a post that is hopefully clear enough for others to understand. Also a big thank you to HockeyMonkey for looking through a number of the PDS’s, and Zennon Damant for help with the grammar.