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).
Kwa says that rather than focussing on the size of a manager’s income distributions, investors need to think about its components. For example, the Schroder Wholesale Australian Equity Fund is tax effective in the sense that 99.6 per cent of its distributed gains this year were subject to a capital gains discount. With the capital gains discount, tax is only paid on 50 per cent of the realised gains of stocks that have been held for longer than 12 months. According to Schroder, the difference the capital gains discount makes between two active funds returning 12 per cent on a $100,000 investment over one year is $1395.
In addition to knowing tax parcels (the proportion of shares eligible for the capital gains discount), tax-effective managers also prefer stocks with franking credits, and where possible, they like to participate in off-market share buybacks despite the damage it may inflict on pre-tax ‘headline’ returns. Not many managers are taking these measures at the moment, according to Friend at Warakirri. “There is a misalignment of interests,” he says. “Fund managers are incentivised to deliver pre-tax returns, when investors want and get post-tax returns.”
Paul Fiani, founder of Integrity Investment Management, is keen to increase the focus on after-tax returns and also dispel the notion that index managers are naturally more tax-friendly. “We factor the franking credit value into our discounted cash flow models, it’s a fundamental measure for us” he says. “If you factor the value of franking credits in to your decisions, it gives you franking leakage which hurts your performance on the pre-tax side, but you can come out way in front on the post-tax side, particularly if you emphasise capital gains efficiency in your sell discipline as we do.”
Warakirri’s Friend says that in 2005, less than 25 per cent of funds managers had accurate data on the tax liabilities in their share parcels, information he believes every funds manager has a responsibility to know.
But not everyone is convinced. Tom Elliot, managing director at MM&E Capital, a hedge fund, describes the move towards after-tax reporting as “dumb”. Elliot warns that if post-tax reporting becomes the focus, managers could fall into the trap of concentrating on tax rather than trying to achieve the best performance. “Using tax to justify decisions is just bad investing,” he says. “If you sit there worrying about that kind of thing, in the long run you will make incorrect decisions. If you wanted to be cynical, you might even suppose that funds managers are now boasting about their tax effectiveness to divert attention away from the fact that they’ve lost 20 per cent this year.”
Blindly trying to capture tax efficiency can lead to poor decisions, admits Justin Wood, head of strategic solutions and client advisory group at Barclays Global Investors. Wood says that there are many factors beyond the manager’s control, such as whether a fund is growing, stable, or declining, or whether a sudden draw down forces some capitalisation, that can have tax implications and need to be worked out. “That’s why IFSA’s recommendation is a guidance note and not a standard,” he says. “It will require some testing.”
Robin Bowerman, principle and head of retail at Vanguard, adds that after-tax regulation hasn’t changed the way money was invested in the US, it has just meant that investors now have more information. “[Despite the direction of the US] we’re not convinced after-tax reporting needs to be regulated – nobody wants extra regulation – but if the clients, especially the super funds, are demanding it, then the fund managers will doubtlessly comply.”
Bowerman says that after-tax reporting is not supposed to be an indictment on high-turnover managers such as hedge funds. “These managers still have a place in the portfolio; knowing the tax implications can help investors decide how they fit,” he says.