I've been asked several times recently what to do with a sum of around NIS 100,000. Aside from the practical debate over which instruments to invest in, and in what proportions, the question is, how can an investment plan be implemented when the sums involved are relatively small? What are the alternatives, and their advantages and disadvantages?
Until two or three years ago, there weren't that many options, with mutual funds more or less the only choice. The option of having an investment house manage your portfolio still exists, but in most cases the minimum sum required to open a portfolio is higher than NIS 100,000. In addition, the belief at many of these institutions is that both customer and investment house would be better off if the portfolio were managed in small sums through the investment house's mutual fund.
Since the Bachar reforms went into effect, many changes have taken place in the market (not all of which were related to the reforms), and the result has been a wider range of vehicles for investing small amounts. Generally, there are three vehicles - mutual funds, exchange traded funds (ETFs), and insurance products (financial policies). Structured deposits are another alternative, but as investment characteristics differ from product to product, and the range of products on offer is vast, they have not been included in this review.
Choosing your options
There are a number of factors that can help you make a decision, and they apply to large investment portfolios but even more so to small ones. They are costs, taxation advantages, simplicity, flexibility, and transparency. The investor's investment profile also has a direct impact on the choice of investment instruments. I will take a brief look at the three types.
- Mutual funds - For the purpose of this review, I will ignore money market funds, which, as an investment instrument, are short-term by nature. Compared with the rest of the world, mutual funds in Israel are expensive. Management fees of 1-2.5% a year in fixed income funds, and 2-4% a year in equity-based funds are unquestionably high.
- ETFs - ETFs have now been on the market for several years, but over the last two years the sector has seen significant expansion, and the range of options today is by no means limited to funds that track the Tel 100 Index. There are ETFs that combine bonds and equities, leveraged ETFs, short ETFs, and others.
- Financial policies - the popular ones are offered by four institutions - Clal Insurance, Excellence-Phoenix, (Excellence Invest), Menorah (Menorah Top Finance), and Harel (Migvan). The policies give the investment portfolio the safety net of an insurance policy with all that entails. The principal advantage is zero tax events until the day the policy is realized. In addition, the management fees remain fixed throughout the policy life and cannot be changed. Other advantages are the ability to deposit large sums by direct debit, and the saving on the custody fees usually charged by banks.
Rules of thumb
There is no clear answer as to which instrument is the best. Each instrument has its own characteristics - just as each investor has his or her individual needs. A comparison of instruments cannot be based on past returns, since there isn't sufficient information about most of them.
Note the rules of thumb here - a tax deferment is an advantage, as is low costs, especially in sophisticated instruments, where it is difficult to create added value by active management.
I will assess the pros and cons of each vehicle by looking at the two main investment channels - equities and fixed incomes.
The equity component
When an equity-based mutual fund charges a 3% management fee, it will find it hard to produce a better return than that of a corresponding ETF over time - assuming that they both specialize in leading indices. In principle, the more sophisticated the market is, the harder it will be for the mutual fund to create an advantage, since exploiting market distortions is difficult, if not impossible. Therefore, a fund focusing on Tel 100-listed equities will usually not have an advantage over a corresponding ETF over time.
The mutual fund may have an advantage on less important indices, such as the Yeter Indices. However, on old-new solution was recently added to the market in the form of index funds, which are funds that track equities. Migdal Capital Markets was the first to offer a product like this under the name Migdal Tracking Fund (MTF), which tracks the Tel 25, Tel Aviv 75, and Tel Aviv 100 Indices. MTF, it should be stressed, is the name of Migdal's product and not a generic name for funds that track indices.
Aside from the unsuccessful attempt, as I see it, to give it an appealing name, it looks like this is an excellent product, since it is cheap, allows tax to be deferred until the date of the sale of fund, is easy to invest in, and is subject to the most stringent supervision of all the various investment instruments, since it is a mutual fund.
A survey conducted by the excellent fund site Funder reveals that, since its launch, this product has tracked the relevant equities indices more accurately than the corresponding ETFs. Its key advantages over ETFs are the tax deferment and costs. If a dividend is distributed by an ETF, it creates a tax event. But since MTF is, in fact, a tax-exempt fund, the distribution of a dividend does not create a tax event for the investor. In addition, an index fund is more suitable for regular purchases than an ETF, since it can be bought by direct debit, cost-free. An ETF is a security, hence any purchase will carry a commission.
On the face of it, the ETF has an advantage in that it is continuously traded throughout the day, as opposed to a mutual fund, which is traded once a day only. But this advantage does not apply to most investors, who do not carry out frequent transactions, and therefore do not need continuous liquidity. Daily liquidity will suffice for them.
Financial policies have an advantage over mutual funds in terms of costs, since the maximum management fee is 2%. Likewise, the policies have a taxation advantage over other investment instruments, and any change in the investment mix is made under the policy framework, and thus does not create a tax event. Like funds, deposits in policies can also be paid in by direct debit; hence they are especially suitable for a current investment.
The bottom line
- The Index Fund is the best solution for investing in the Tel 25, Tel Aviv 75, and Tel Aviv 100 Indices, especially if a regular periodic investment is being made.
- ETFs are a good solution for investment in less important indices, equities indices overseas, and more aggressive indices, such as commodities, leveraged indices, short indices, etc.
- Funds are good principally for niche instruments, since they allow for diversification, and access to specialist instruments. However, the costs are high.
- Financial policies are a reasonable solution for anyone interested in a local diversified portfolio, principally because of the tax advantage. Beyond that, it is doubtful whether they are preferable over a combined investment in an index fund, ETFs on secondary indices, and some slightly more exotic mutual fund.
The fixed income component
Financial policies lose their cost advantage when it comes to fixed income, since they are more expensive and charge a 2% management fee. As far as securities taxation is concerned, they are still better, but funds also allow for tax to be deferred to until redemption. Assuming that the number of requisite changes in a fixed incomes portfolio is not high, the taxation advantage in financial policies is less significant. The principal question is whether mutual funds have an advantage over ETFs when it comes to fixed income. There is no clear cut answer to this, and it depends on the type of bond and level of liquidity.
I cannot see much of an advantage for funds over ETFs when it comes to government bonds. The funds' surplus costs are a substantial disadvantage in a sector where the return is not high to begin with.
The situation in corporate bonds is less unequivocal, since this market is not yet completely developed and the liquidity in many securities is low. A good fund manager can exploit pricing distortions in illiquid securities. That said, last year the TASE launched corporate bond indices and naturally, the ETF tracker funds for these soon followed.
Is an investment in an ETF tracking the Tel Bond 20 or the Tel Bond 40 preferable to an investment in a mutual fund? Perhaps not, but considering the management fees in funds, the competition with parallel ETFs is intense. ETFs offer an advantage for anyone looking for a pure debt investment, since he knows that this is exactly what he will get, in contrast to debt-based mutual funds, which sometimes have a low exposure to equities (legal, of course, but not always evident).
The bottom line
- ETFs are preferable when investing in government bonds.
- If the investment is in corporate bonds, mutual funds and/or ETFs could also be suitable. Financial policies have a slight advantage in taxation, but have a disadvantage in cost.
The writer is a financial planner at Pioneer Global Markets. The opinions in this article should not viewed as a recommendation to buy or sell securities, or an alternative to personal investment advice.
Published by Globes [online], Israel business news - www.globes-online.com - on April 28, 2008
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