Towers Watson was scheduled to publish a paper on the subject as this issue of Investment Magazine was going to press. Russell’s Williams agrees that share buyback opportunities represent lost value for super investors – what she calls “the cost of a pre-tax mindset”. According to Williams, the current Woolworths off-market share buyback offer can add around 30bps in returns after tax to a super fund holding the stock at benchmark weight – clearly a good deal even though it would cost the fund in pre-tax returns. Perhaps one reason that some managers have ignored buyback opportunities is that from a manager’s performance perspective, when the consultants and clients are measuring returns pre-tax, participation in a share buyback will not positively impact published performance. John Nolan, the executive director, investments, at Warakirri, was recently joined at the firm by his son Andrew, who is head of investor solutions. Andrew completed an MBA at Georgetown University in the US and worked for Wellington Management Company LLP in Boston.
He also had a variety of equity roles at Commonwealth Bank before going overseas. Andrew Nolan says that managers need to be measured on an after-tax basis. It makes sense to focus first on Australian equities for after-tax measurement and reporting because it is still the largest asset class for most funds and Australian equities are actively traded. “Franking credits alone can add or subtract 50bps from (benchmark relative) returns,” he says. “When you take account of capital gains tax as well, for managers to be measured and rewarded on a pretax basis just doesn’t make sense.” John Nolan says he has seen instances of managers trading in the 51st or 52nd week, of a stock being owned by the super fund, yet the nominal gains realised before 52 weeks are taxed at 15 per cent and discount gains realised after 52 weeks are taxed at 10 per cent. In a live example, when measured on an after-tax basis, managers reduced their sale of nominal gains in weeks 51 and 52 of trading by between 35-91 per cent. In another live example over the 12 months to June 2010 two managers delivered the same before-tax alpha but with a variance of 0.54 per cent after tax (below).
In this example, Manager B realised more gains on shares held for less than 12 months than Manager A and was therefore subject to more capital gains tax at 15 per cent. Manager B also earned less franking credits than Manager A. It took Warakirri a couple of years to develop its methodology for after-tax benchmarking, which was introduced across most managers in July 2007. Andrew Nolan says that proper comparisons require that the benchmark has the same embedded loss or gains at the start of the measurement period as the portfolio. When there is an inflow or distribution from the portfolio, you have to adjust the benchmark to mirror these. Warakirri sends each manager the tax status of all share parcels every month so the portfolio managers can make rational decisions. Then they are given a reconciliation of pre-tax and aftertax returns so they can understand the difference. “We’re not saying ‘if you think the company’s going to go broke tomorrow you should delay the trade to reduce tax’. But at least you should have all available information to make the right decision for the client,” John Nolan says.