Index managers have to date secured the most airtime in the debate on after-tax performance measurement in Australian equities. But active managers are urging investors to consider a wider picture, STEPHEN SHORE reports.

 The suggestion that investment returns should be reported after tax has, historically, often been met with resistance by funds managers. But now that an increasing number of lucrative superannuation clients are beginning to demand it, and the Investment & Financial Services Association has released its guidance note, more are warming to the idea. Richard Friend, head of portfolio management at Warakirri Asset Management believes that within two years publishing post-liquidation returns is likely to become the industry standard.

Investors are supportive of the initiative for obvious reasons; it makes comparisons between the real returns of managers easier to calculate and compare, and it encourages managers to be more tax effective in their trades. When measured on pre-tax performance, managers have no incentive to minimise the tax they incur, nor reason to be concerned how tax will affect the return ultimately delivered to clients. Indeed, there have been reported cases of managers making decisions to the detriment of real returns in the interest of maintaining headline performance figures.

As Max Cappetta, executive director at Continuum Capital Management, (borrowing from management guru Peter Drucker) says: “What’s measured gets managed.” Some styles of managing money are more naturally aligned with tax effectiveness than others, and it is not surprising that these managers have been the most enthusiastic about moving towards an industry standard of after-tax reporting.

Index managers Vanguard Investments have been among the most ardent and vocal supporters. Tax effectiveness is a serendipitous by-product of managing an inherently low-turnover portfolio.

Last year the turnover in Vanguard’s flagship Australian shares trust was less than 5 per cent. Compared with the average active Australian equities manager, Vanguard realised much less capital gains, and thus paid much smaller distributions, incurring a much lower annual tax bill. If the returns of all managers were calculated in real terms, after-tax, Vanguard’s (typically conservative) annual performance in the league tables suddenly becomes a lot more impressive.

Vanguard has been reporting the after-tax returns on its index funds since 2004, and its parent agitated the debate in the US, where after-tax reporting has been mandatory for all funds managers since 2001.

Yet a low tax bill year-to-year is only half the story, according to Stephen Kwa, investment specialist – quantitative equity products, at Schroder Investment Management. He says that index managers often neglect to mention that investors will be in for a much larger capital gains tax bill whenever the money is eventually redeemed. “You can defer tax, but you can’t avoid it,” he says. Despite a higher turnover of 15-25 per cent (relatively low for an active manager), Kwa claims that over a one year period, Schroder’s active Wholesale Australian Equity Fund is just as tax effective as a passive fund, and assuming the same performance, the final redemption value after tax will be exactly the same (of course, Kwa tacitly assumes the Schroder active performance will be better).

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