Question

You recently graduated from university, and your job search led you to Coles Group Limited. Since you thought the company’s business was very promising, you accepted their job offer. As you are finishing your employment paperwork, Michel, who works in the Finance Department, stops by to inform you about the company’s new superannuation plan. Australian companies offer membership of a superannuation fund to their employees, where their Superannuation Guarantee contributions are saved. Superannuation funds have concessional tax arrangements, which saves tax if you save for your retirement through your fund. So, if you can make contributions to the fund from your pre-tax income (known as salary sacrifice), contributions are deducted from your current salary, and no current income tax is paid on the money, and the super fund pays only 15% tax on the contributions. For example, assume your salary will be $130 000 per year. If you contribute $7200 pre-tax to the superannuation fund, you will pay taxes on only $122 800 in income. Taxes will be payable on the initial deposits at 15% and on any capital gains or fund income while you are invested in the fund, and you will not pay taxes when you withdraw the money at retirement, provided you retire at or after turning 60. At Coles, you can contribute up to 6% of your salary to the plan, which will be saved in the fund with your 9% Superannuation Guarantee contributions. The Coles superannuation fund has several options for investments, most of which are managed funds. As you know, a managed fund is usually made up of a portfolio of assets. When you purchase shares in a managed fund, you are actually purchasing partial ownership of the fund’s assets, similar to purchasing shares in a company. The return of the fund is the weighted average of the return of the assets owned by the fund, minus any expenses. The largest expense is typically the management fee paid to the fund manager, which makes all of the investment decisions for the fund. Coles Group Limited uses Down Under Financial Services to manage its superannuation plan. Michel then explains that the retirement investment options offered for employees are as follows: Down Under All Ordinaries Index Fund. This fund tracks the All Ordinaries Index. Shares in the fund are weighted exactly the same as they are in the All Ordinaries Index. This means that the fund’s return is approximately the return of the All Ordinaries Index, minus expenses. With an index fund, the manager is not required to research shares and make investment decisions, so fund expenses are usually low. The Down Under All Ordinaries Index Fund charges expenses of 0.20% of assets per year. Down Under Property Trust Fund. This fund invests primarily in property trust shares. As such, the returns of the fund are slightly less volatile than the All Ordinaries Index. The fund can also invest 10% of its assets in companies based outside Australia and New Zealand. This fund charges 1.70% of assets in expenses per year. Down Under Bond Fund. This fund invests in long-term corporate bonds issued by companies domiciled in Australia and New Zealand. The fund is restricted to investments in bonds with an investment grade credit rating. This fund charges 1.40% in expenses. Down Under Money Market Fund. This fund invests in high-quality debt instruments, which include bank bills and government bonds. As such, the return on money market funds is only slightly higher than the return on government bonds. Because of the credit quality and nature of the investments, there is only a very slight risk of negative return. The fund charges 0.60% in expenses. Using the information provided, answer the following questions:

I. Assume you decide you should invest at least part of your money in an All Ordinaries Index fund of companies based in Australia. What are the advantages and disadvantages of choosing the All Ordinaries Index fund compared with the Bond Fund?

Answer 1

If I decided to invest a part of my savings into All ordinaries Index fund of companies based in Australia, I will have following advantages associated with the investment-

A. This is a kind of passive investment and the risk is weighted according to to the weighted of risk in all weighted index, hence this is preferable for long term investment and there is no risk of negative return also.

B. Investment in this fund is highly secured because this fund will only invest into assets which are of investment grade and which have a high recovery power associated with them as investment grade assets means those assets whose realisation is almost certain in every economic scenario.

C. These funds will have more than risk free rate of return and it will not have any negative return from the market because it is invested in same proportion according to the the all weighted index.

D. There is lesser standard deviation of the portfolio as the returns are less volatile in comparison to other funds so the investor will not feel getting exposed to high beta fund.

Disadvantages associated with investment into all index weighted fund are as follows-

A. This is costly fund as there is high expense ratio associated with it as well as there is also higher fund charges associated with investment.

B. The return would not be very higher since it is investing into almost risk free Assets and investment grade bonds So, there would not be a severe outperformance on the part of the market. It will not yield higher rate of return.

C.The risk associated with investment in these bonds are extremely lower so the reward making possibilities and the return making possibilities are also lower, as there is a direct relationship between the risk and reward so there would be lower probability of higher returns.

D. These funds are only suitable for those investors who are conservative in nature and who do not like any risk in their portfolio so there are a very few number of investors who like passive investment at this time.