Castro agrees. She says if investors are paying managers on a basis point measure after-tax, then you need an accurate measure. However, a range of things outside the managers’ control could affect the after-tax return. Cash flow is one, but the age of the shares is another key one.
Take two managers with identical portfolios: one portfolio is less than a year old, and the other was over a year old. If they had to sell the same shares, their return would be the same on a pre-tax basis but their after-tax return would be quite a different story. She points to a graph showing a range of managers that tracked the same benchmark, but their different “starting points” – the age of the tax parcels in particular – has given them quite different after-tax benchmarks.
Establishing these individual benchmarks helps remove any confusion over the performance of different managers. There are a variety of ways of measuring an after-tax benchmark, Castro says, but industry best practice – the one Warrakirri has in place – is to “replicate” the manager’s portfolio and measure the trading activity of the underlying component shares. In other words, ITG takes the starting point of the manager – whether it is a cash amount or shares, and how old those shares are. It also needs to know what tax rate the manager is on, and what generic index they are investing in. Then on a daily basis, the manager tells ITG what their cash flow is, or any in-specie transfers in or out of the portfolio.
“We need to know that so the index also removes or adds that amount and buys or sells some shares.” The only other information required by ITG is whether any companies in the manager’s portfolio are having a buyback.
Castro and Friend are both somewhat critical of fund managers not participating in share buybacks because it pulls down the (pre-tax) performance figures, even though it’s often better for the end investor on an after-tax basis. The software running the after-tax index sits in ITG’s offices, and the manager just sends the information through. The manager receives a daily report – much the same as it would receive from any other indices benchmarker – as to where the after-tax benchmark is that day.
ITG is currently calculating around 40 after-tax indices for managers. It runs 400-plus more general indices already. Castro says the argument that after-tax costs money is not supported by what ITG has seen with the benchmarks. “Managing in a tax aware manner can save you money and save you performance,” she says.