Fund managers dragging their feet on investing for post-tax performance may find the primary excuses for ignoring the tax bill and consequently the investors’ forfeited returns are coming undone. One thing underpins this unravelling – it’s called technology. CATHERINE JAMES looks at the advancements driving the after-tax debate to its inevitable conclusion.
It’s been said a hundred times before that time and tide waits for no man. Technology should be added to the list. Tania Castro, Investment Technology Group (ITG) market data analytics product manager, says the increasing efficiency of data automation will eventually render the after-tax question as passe as the question of daily or after-fees reporting.
Years ago, Castro says, people were only reporting quarterly or monthly returns, and calculations were such a huge task that more frequent reporting was resisted, but technological advances ensured frequent and after-fees reporting ultimately had to be embraced, or else players risked being left behind.
Managing a portfolio with tax implications in mind will follow a similar trajectory. Constantly relegated to the too-hard basket, reporting after-tax returns is being facilitated with increasingly sophisticated software and systems. Once reporting after-tax returns becomes more common and as investors take stock of it, the natural evolution will be for fund managers to manage with the tax implications in mind.
But any question about managing a portfolio on an after-tax basis is closely followed by the question of how to know whether the manager is truly being tax effective, or just saying so. Enter ITG. The investment technology group has developed software that calculates a customised after-tax benchmark for each manager. ITG is also at the forefront of systems being developed to aid fund managers with an after-tax portfolio. But firstly, the benchmark. Why must each manager have an individual index?
Richard Friend, head of portfolio management at Warrakirri Asset Management – where benchmarks have been running for each of it’s 22 underlying managers for the past year – says it largely comes down to cash flow. Different cash flows in two managers investing exactly the same way will result in a different after-tax return.
“Where we’re coming from as an investor, if we’re measuring our managers on a post-tax basis then we have to make the game fair. That’s why you need individual benchmarks,” he says. “We’ve been running [after-tax benchmarks] for one year, and the largest difference between two managers on the same benchmark was 55 basis points. So if you’re measuring someone’s performance they’re not going to be too happy if you’ve got an error of 55 bps, especially if it’s a manager who’s on a performance fee deal – that can directly affect their remuneration.”
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.
“After-tax doesn’t mean you change your style of trading – I think that’s where some of the people in the industry get scared and think they have to become an index manager. That’s not the case. All you’re really being asked to do is add one extra thing that you look at when making investment decisions”.
ITG charges a flat fee for the benchmark, which Friend says is cost effective. He also says the benefits far outweigh the costs of implementing the after-tax environment. ITG also runs software that can aid a manager in determining the best trading decisions for after-tax performance.
Castro calls it “tax lot optimisation”. It helps the manager select which tax lots should be sold at a given time in order to optimise returns. Instead of the manager simply choosing a methodology that hinges on selling the oldest tax parcel first (to avoid capital gains, for example), the software facilitates deeper analysis. Castro says more information would be required from the manager for such analysis, and in this case, ITG acts more like a custodian than a benchmarker.
The Investment and Financial Services Association recently released a guideline for its members to report their after-tax returns. However, Robin Bowerman, Vanguard retail principal, says this move is focused on the retail market insofar as it will allow financial advisers and consumers to be more aware of what the tax implications of different managers are in light of their personal income tax rates. The reporting guideline should not be confused with a push towards managers investing with the aim of reducing the tax bill.
“The tax bill is probably one of the largest the superannuation funds will have to pay,” Bowerman says, so it makes sense for managers with a super fund mandate to be conscious of that. Castro believes eventually it will catch on to all managers when the reporting kicks in, investors start noticing, and managers across the board – retail or institutional – realise the cost effectiveness.
“We do the same thing with transaction cost analysis: if you can minimise your costs by minimising transaction costs, then that’s money for jam. If you just lost three basis points because you didn’t look at how your systems were doing, then that’s very hard to justify.
“And that’s what it’s all about – how much money can you come back to the investor with? My question to those who say [being tax-aware] is going to cost too much: do you actually know how much it’s costing you?”