Key Post: Buying shares directly or through a Unit Linked Fund

For the purposes of discussion I am comparing buying shares directly with buying a low cost unit linked fund such as a Quinn Life tracker with no initial charges and a 1% annual management charge

Advantages of Unit Linked Funds
More favourable tax treatment for high yielding shares
Less administration
Greater spread of investments
No initial charges
More liquid

Advantages of Investing Directly
More favourable tax treatment for high growth shares
A big saving in annual charges
More fun if you like following shares
A minor advantage - shareholder perks

Tax treatment
There is no tax within the fund on unit linked funds. You pay a 23% tax on profits, when you exit.
You pay 45% tax and levies on the dividends each year if you hold shares. You pay 20% on any capital gain you make when you sell the shares. Assuming a 3% annual dividend and a 5% nominal capital gain, €100 invested today in shares would amount to €168 after 10 years, whereas €100 invested in a unit-linked fund would amount to €178. If the dividend yield forms a higher proportion of the total return, unit-linked funds would be even more attractive, whereas if the capital growth element was higher, the tax treatment favours investing directly in shares.

If you die while you hold your shares, there is a huge advantage in holding shares directly as no CGT is payable on death.

Performance
I assume that there would be no difference in performance between a professional manager and a direct investor in shares. If you believe, against all the evidence, that you have the skill to pick winning shares consistently, then this would be the most important issue. Of course, if you believe, against all the evidence, that you can predict which fund manager will outperform the market, then this would favour going for a fund manager.


Low cost unit linked funds are suitable for short term investors
Commission and stamp duty make buying shares directly unsuitable for short term investors. You will have buying and selling costs of around 4% to pay. If you are comfortable with the risk/reward tradeoff of short term investing, you would be far better off investing in unit-linked funds, as you won't face this cost.

Unit linked funds are more appropriate for investing overseas
There is very little administration involved in buying Irish shares directly. If you buy overseas, you may have to keep the shares in a nominee account. You may have to buy foreign currency to buy the shares. You may get the dividends in a foreign currency.There may also be taxation issues. All these factors would strongly favour buying overseas shares through a unit linked fund.

Re: Buying shares directly or through a Unit Linked Fund ?

If you die while you hold your shares, there is a huge advantage in holding shares directly as no CGT is payable on death.

How does this work? As far as I know, on death any shares held must be transferred into the name of the inheritor (for which the registrar will usually charge a fee and require some sort of legal authorisation - e.g. grant of probate or whatever). After that disposal may presumably trigger a CGT liability for the new holder of the shares. How can this be avoided since (presumably) the shares cannot be disposed of while in the name of a deceased person?

Re: Buying shares directly or through a Unit Linked Fund ?

The capital gain dies with the person. If someone buys shares for €20K and these are worth €100K when he/she dies, the person inheriting the shares will have their future CGT liability based on a €100K 'purchase' price. If the shares are sold straight away there is no CGT as the inheritor 'acquired' the shares at €100K. There may be inheritance tax though.

Re: Buying shares directly or through a Unit Linked Fund ?

Thanks - that makes sense.

As I see it (please suggest changes/edits to this if incorrect):

Commissions

Option 1: Investing in shares directly - 0.75% one-off charge assuming you invest a minimum of €2,666 in each trade via [broken link removed] sharedealing service. Nothing after this.

Option 2: Investing with Quinn Life - Annual charge of 1%.


Taxes

Option 1: At marginal rate annually on dividends, i.e. 20% or 42%. Let's assume an annual yield of 2.7% (this is the ISEQ 20 yield for 2005 - see link below). At a tax rate of 42%, your annual tax on dividends would be 42% of 2.7% which is 1.13% of total fund value. At a tax rate of 20% your annual tax on dividends would be 0.54%. Then, when you sell your holding, the tax on gains will be 20% (CGT). There will also be a 1% stamp duty on the purchase of shares using this option.

Option 2: No dividend tax but a tax on gains of 23%. This 23% will also be paid on the dividends that have accumulated within the fund. With dividends at 2.7% p/a, the 23% tax (payable on exit) equates to 0.62% of fund value per year.



Summary

...............................Option 1................Option 2........................
Entry Charge.............0.75% of value..........Nil................................
Annual Charge...........Nil...........................1% of fund value.............
Dividend Tax.............0.54% / 1.13%...........0.62% p/a - paid on sale..
Exit Tax ..................20% of gain...............23% of gain....................
Stamp Duty..............1% of value...............Nil.................................


Conclusion (assuming you're a 42% taxpayer)

Option 1: In a 5 year timeframe, the entry charge works out at 0.15% p/a, the the dividend tax works out at 1.13% p/a and the stamp duty on purchase works out at 0.2% p/a. Then when you sell, you'll pay 20% of fund value.

Option 2: There is a 1.62% annual charges as opposed to the 1.38% annual charges when buying shares directly. Then, when you sell, you'll pay 23% on gains.


Which option is best?

As can be seen above, the charges for option 1 works out at 0.05% cheaper per year which is a very minor difference. Then, the tax on gains in the value of your shares works out at 3% cheaper using option 1. Assuming that your shares (without dividends reinvested) rise at 5% per year, after 5 years your gain will have been 28%. Therefore, you would be saving 3% in exit tax on 28% of the fund value = 0.85% of fund value. When this saving is added to your 0.05% per year for 5 years saving in other charges, it means that, after 5 years, you will have saved 1.1% of the fund value by using option 1.

In conclusion, you should invest directly in shares if you view it as a hobby and enjoy reading the financial pages of the newspapers and like the idea of choosing your own shares. Otherwise, if you would prefer a set amount of money coming out of your bank account each month and being invested in a fund by your fund manager, you should invest via quinn life. The differences in charges do not make enough a difference to have a major affect on the value of your investments. I should mention at this point that one additional advantage of investing directly in shares is that, each year, you get a CGT allowance of €1,270. This means that, every year, you can sell a portion of your shares that have risen in value by €1,270 and avoid paying the 20% exit tax thus saving an additional €254 (less the €20 charge for selling them). This works well if you think that a particular share in your portfolio has risen in value excessively and is now overvalued.

ISEQ 20 Yield:
[broken link removed]

You must now also consider the new 8-year rule when investing in Unit Linked Funds. For more details of this, see the following thread:

http://www.askaboutmoney.com/showthread.php?t=58536

Also, my post above assumes stamp duty at 1%. Of course, this is only applicable to Irish shares. If you purchase UK shares this will reduce to 0.5% and will reduce to 0% for European and US shares. You must also understand that there is a currency risk involved when purchasing UK or US shares - which will obviously also apply to US or UK unit linked fund.