A look at how investments are priced and why the end of financial year can lead to panic stations.
I often receive phone calls from clients, in the early weeks of a new financial year, somewhat distressed at by the fact that the value of their investment portfolio has fallen by a significant amount more than what is reported in a market update the night before.
After speaking to several advisers, and it becoming apparent that this was a common line of enquiry, I came to the following line of thought.
In our industry, we focus on educating our clients so that they can understand what is happening to their underlying investments and subsequently how their portfolio may be impacted by events noted in the media.
For me, analogies are a fantastic way to illustrate what can be at times a confusing or complex situation and after a colleague conveyed the story of the cow and the calf, it finally dawned on me what the missing link was.
Before I start, it is important to highlight the key factor in the equation, being that a managed fund is a unit trust.
Trust Law, in its nature, requires that all income (interest, rent, dividends and capital gains) be distributed at the end of each financial year.
There is no discretion allowed by the Trustee.
Some managed funds may pay monthly, quarterly or semi-annually, but all earnings must be reconciled at the end of financial year to determine what must be distributed.
You may recall that fund managers, take their time to provide you with a tax statement to provide to your accountant, summarising the components of all distributions paid during the financial year.
With the facts established, let me carry on with the analogy..
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If you went to the sale yards and there were two cows in separate holding pens, one that was pregnant with a calf and the other barren, you would expect to pay more for the cow with the calf, wouldn't you? Of course you would, because you are getting more than one animal (potentially).
The calf represents the future potential income that you may receive as the owner of the cow.
Taking it one step further, 1 July of each year effectively represents the net price of the cow.
By this I mean, that any accrued income (the calf) has already been paid our to unit holders.
However, it is important to bear in mind that the 'extra' value could easily evaporate if the cow does not deliver.
This too can happen with a managed fund, where the income within the fund could be absorbed by capital losses previously realised.
So 'potential' is the operative word.
Following on from this, the arrival of 30 June each year sees the calf being delivered and the price of the cow restored to its original price (plus some appreciation due to market forces.
The calf is the distribution that investors are either paid into their cash account or automatically re-invest (if nominated).
More often than not, the calf is delivered but remains in 'quarantine' while the value of the cow immediately falls so that any new buyers know the 'true' price of the cow on its own (net of calf).
This is where investors get anxious because the value of their investment (the cow) has fallen but there is nothing to offset the net change in value recorded on 30 June.
The cash (the calf) is distributed typically in the second week of July or and as late as October, (depending on the investment).
In general, if when you add the value of the distribution (the calf) to the 1 July unit price (the cow), you will arrive at the 30 June unit price (the pregnant cow).
I suppose this is a somewhat longwinded story to assist you in understanding what actually happens at the end of the financial year with the pricing of managed funds, but it is important to note that all investments are priced in the same way -- it is just that it is more pronounced with managed funds.
This occurrence is even evident in something as simple as a client's direct share holding whereby dividends paid through the year resulting in the security trading ex dividend (ex calf).
Too often we look at the price of an investment and compare what we paid for it with what it is worth today.
Regretfully, the only realised return, being the income that has actually been credited to our bank account, is forgotten.
I encourage you to assess your investments on what it has returned to you through income, as well as the current price of the asset.
The next time your investment falls in value for an unexplained reason, ask yourself, has it just given birth to a calf, or has someone stolen it from your property and is taking it to the abattoir?