Key Post ISEQ ETF vs unit linked funds vs. holding shares directly

I thought I had done a Key Post on this before, but I can't find it. If anyone else finds it, I hope I don't contradict myself too much ( After writing the following, I have found it: http://www.askaboutmoney.com/showthread.php?t=6805)

This is a work in progress, so comments and corrections welcome.

Tax Treatment
ISEQ ETFs
Dividends are subject to 20% tax with no further tax liability due.
Profits on disposal will be taxed at 23%

Unit linked funds
Exit tax of 23%

As the dividends are paid out each year, the tax is paid each year. With the Unit linked funds, the fund grows tax free. So there is no real difference between them.

Direct holding in shares
Dividends taxed at marginal rate - which is 46% for most people
Capital Gains taxed at 20%
First €1270 of gains exempt from CGT each year
No CGT payable if you die

Initial costs
1% stamp duty on shares - no stamp duty on ETFs or unit linked funds

Commission on buying and selling ETFs and shares - up to 1.5% each way.

Many unit linked funds available with no initial or exit charges e.g. Quinn Life.

Annual costs
None for shares
.5% for ISEQ ETF - now charging 1.9% as of May 2009
1% for Quinn Life Unit fund ( other funds may be cheaper for very large amounts)

Diversification
Unit linked funds are most easily diversified in that you can allocate your money over many different funds e.g. Irish and European


Administration
Shares require some administration e.g. tax returns, dealing with scrip issues etc.

Which is better?

If you invest €100 and the dividend yield is 2%

In the ETF you will get €2
Less annual charge €0.5
Less 20% tax €0.4
Net income €1.1

With shares, you will get €2
less 46% tax €0.92
Net income €1.08

So the difference is 3 cents per €100 i.e. it is insignificant.

I conclude that you should invest directly in shares as the CGT is lower and because the exemption on death is so valuable.

Brendan

A few observations/questions:

(1) I knew the dividend on the ISEQ 20 ETF is taxed at 20%, but I thought it was deducted at source. When I got my first cheque in January, it appeared to be for the gross amount. Do I have to declare and pay this myself, or am I missing something?

(2) Capital gains on direct share investment are taxed at 20%. Gains in the ETF are taxed at 23%. Surely a further advantage of direct investment?

Brendan said:

The tax on the capital growth is the same apart from the CGT exemption.

Click to expand...

(3) If one wants to replicate the ISEQ 20 composition investing directly in shares, one would have to rebalance one's shareholdings from time to time to reflect changes in the index's composition and the market cap of component shares. Transaction costs and stamp duty would be incurred, whereas the ETF would do this automatically within the annual 0.5% charge. Also the process of selling shares to do this would crystallise the associated capital gain or loss, whereas the ETF doesn't. These are pluses for the ETF.

(4) Some shares in the ISEQ 20 provide the option of scrip dividends, the ETF doesn't. Reinvesting dividends can be a big factor in long term investment growth - this is a negative for the ETF in my view.

1) Don't know

2) Thanks. I have corrected my second post accordingly.

3) Rebalancing is not really that significant. You would not try to replicate the ISEQ. You could just buy 5 shares and they might do better or worse than the ISEQ. The only need for rebalancing would be if one got way out of kilter with the others.

4) I don't see why the scrip dividends make any difference. You can just buy some more ETFs with the actual dividends.

Brendan

Brendan said:

Rebalancing is not really that significant. You would not try to replicate the ISEQ. You could just buy 5 shares and they might do better or worse than the ISEQ.

Click to expand...

I disagree. Many investors (including me) would like the exposure to a stock market without wanting to take the time or effort to research the individual companies and choose which to invest in. This is why index tracking funds are so popular. Also, if you look at the weighted makeup of the ISEQ 20, over 60% (by market cap) is in four shares. Three of those four are banks. The market cap of many of the remaining 16 is too low for it to be cost effective for a small investor to buy them in proportion to their weightings. On the other hand, having them included in one's ETF investment provides valuable diversity.

Brendan said:

4) I don't see why the scrip dividends make any difference. You can just buy some more ETFs with the actual dividends.

Click to expand...

Stockbrokers charge a minimum commission. For most individual investors, to reinvest what would probably only be a couple of hundred euro for each six-monthly dividend would cost a disproportionately high percentage of the dividend. There is no similar charge on a scrip dividend. Also, the scrip dividend would make it more convenient - you would just complete the necessary mandate once and each subsequent dividend is automatically reinvested. These are precisely the reasons many individual companies already offer scrip dividends.

Hi Gonk

There is no intrinsic reason for replicating the performance of the ISEQ or the ISEQ ETF. Let's say that AIB was removed from the ISEQ through a takeover. What would the difference be in tracking the old ISEQ vs. the new ISEQ?

Your objective is to have a diversified fund with a good return.

The composition of the ISEQ is accidental and not planned. Let's say that Quinn Group floated, we would now have an insurance company in the ISEQ.

I would probably go further and say that what you are calling an advantage of the ETF is actually a disadvantage. The ISEQ might not be adequately diversified for a lot of people. AIB, CRH and Bank of Ireland must account for almost 20% each. A problem with any of them, would have a big impact on your wealth.

If you consider that 10 shares are required for diversification, you are implying that the maximum exposure per share is around 10%. You would be better diversified with 10 of the top shares in equal amounts. It would not replicate either the ISEQ or the ISEQ ETF, but it would be more diversified.

It might well perform better or worse than the ISEQ - we have no way of knowing in advance.

Brendan

(4) Some shares in the ISEQ 20 provide the option of scrip dividends, the ETF doesn't. Reinvesting dividends can be a big factor in long term investment growth - this is a negative for the ETF in my view.

Click to expand...

That was your original point. You can still reinvest the dividends. It might be a little bit more hassle. The costs might be a tiny bit higher. But you can still reinvest the dividends and they will still be a big factor in the long term investment growth.

Brendan said:

With the Unit linked funds, the fund grows tax free. So there is no real difference between them.

Click to expand...

Were the rules changed recently where tax is now payable every 7 (?) years?

Brendan said:

There is no intrinsic reason for replicating the performance of the ISEQ or the ISEQ ETF.

Click to expand...

True, but I thought you were aiming to produce a like-for-like comparison between investing in the ETF, unit linked funds, and direct share purchasing. There is nothing wrong with your suggestion of buying five shares - it's just not directly comparable with buying the ETF.

Brendan said:

The composition of the ISEQ is accidental and not planned. Let's say that Quinn Group floated, we would now have an insurance company in the ISEQ.

Click to expand...

Since it comprises the 20 largest cap shares in Ireland, it can be regarded as a reasonable proxy investment for the Irish economy as a whole. As the economy changes and the ISEQ 20 changes to reflect this, so automatically would the ETF. This can be regarded as an advantage of the ETF. By the way, there is already an insurer in the index - FBD.

Brendan said:

The ISEQ might not be adequately diversified for a lot of people. AIB, CRH and Bank of Ireland must account for almost 20% each. A problem with any of them, would have a big impact on your wealth.

Click to expand...

Also very true - the ISEQ 20 is heavily biased towards banks and construction. I would not advise the ISEQ 20 ETF as the only equity-based investment for anyone who was in a position to diversify more widely. But it remains a fact that a direct investment in five shares as you propose would be even less diversified than the ETF.

Brendan said:

If you consider that 10 shares are required for diversification, you are implying that the maximum exposure per share is around 10%. You would be better diversified with 10 of the top shares in equal amounts. It would not replicate either the ISEQ or the ISEQ ETF, but it would be more diversified.

Click to expand...

For a small investor, the more individual transactions, the higher the transaction costs as a proportion of the investment. This would produce higher diversity, but at a significant cost. Two advantages of the ETF are its convenience and lower transaction costs. For sure, it has other disadvantages, especially the tax treatment of gains.

Brendan said:

It might well perform better or worse than the ISEQ - we have no way of knowing in advance.

Click to expand...

Again, true, but again also demonstrates you are not making a like-for-like comparison between the ETF and direct share purchases.

Rebalancing is not really that significant. You would not try to replicate the ISEQ. You could just buy 5 shares and they might do better or worse than the ISEQ... we have no way of knowing in advance.

In the long run, it's very likely that it will underperform. If you look at the companies that constituted the S&P 500 40 years ago, only about 15% remain on the list today. A minute 2% of the original list out-performed the index.

The same principle applies to the Iseq or any other index. At least some of today's leaders will be nowhere in 20 years time. Many others will have stagnated and been superceded in their industry by more innovative companies that may not have even been born yet.

If you buy into the index, the losers will be periodically weeded out and replaced by the winners. If you simply buy and hold 5 or 10 individual stocks, on the other hand, you are almost certain to be left holding some dogs that will guarantee overall under-performance.

Brendan said:

You can still reinvest the dividends. It might be a little bit more hassle. The costs might be a tiny bit higher. But you can still reinvest the dividends and they will still be a big factor in the long term investment growth.

Click to expand...

The costs may not be high in absolute terms, but as a proportion of the amount to be reinvested they are huge.

Take an investor who has €10,000 in the ETF. The dividend amounts to approximately 2% and is paid six-monthly. So he gets two payments a year of €100. Tax at 20% has to be deducted leaving two nett payments of €80. The lowest minimum stockbroker's commission I know of is €20, so our investor would be paying an effective commission rate of 25%! If our investor was in for the long term, say 10 years, his extra costs from this over the period would be €400, or 4% of his initial investment. This assumes no increase in the minimum stockbroker's fee, which is not very likely. I think it adds up to a significant amount and brings the effective costs of the ETF close to those of a traditional unit-linked index tracker for smaller investors.

The convenience factor is also significant. The ETF is sold as a low cost convenient way of getting exposure to the ISEQ 20 - it would in my view be significantly more attractive if it provided the option of a scrip dividend.

The weighting of shares in the ISEQ 20 will be rebalanced next month, when the stock exchange starts taking in to consideration each company's "free float". This is the percentage of each company's total shares issued which the exchange considers are available for sale. A higher free float will result in a greater weighting in the index. The ETF's shareholdings will have to change to reflect the new weightings.

See here for more:

[broken link removed]