There have been a number of studies that look at the after-tax returns of investment managers and conclude that for individual taxable investors, most managers do not generate enough excess return to cover the tax bill caused by the resulting capital gains tax. Superannuation funds have a lower tax rate than individuals, but the tax drag caused by frequent trading still creates a difficult hurdle for managers to overcome. For most managers, the alpha they generate does not cover their tax bill. The portfolio manager sells one asset, typically incurring a tax obligation, and buys another asset based on the belief that the trade will benefit the owner of the portfolio. In many cases, however, the resulting tax consequence turns out to be larger than the unknowable advantage of the trade.
Funds that are helping clients reach specific wealth or return goals must acknowledge the role that taxes play in eroding returns.
In 2012, MySuper legislation created a greater focus on after-tax returns and it is clear that, at a minimum, managers need to be tax aware, for example, selecting tax lots appropriately, monitoring franking credits and taking advantage of share buybacks. However, it is also possible to alter the trading and implementation of an investment process, taking some active risk in order to get an improved after-tax return.
Managers need only pay adequate attention to the tax consequences of their actions. Done correctly, the alpha of a sound investment process with a minimum of tax consequences can be captured. It’s a lot of mechanistic and boring work, often as dull as watching grass grow. But, a lush lawn is a worthy goal.
Extract from a Parametric newsletter.
|Day 1 newsletter from CMSF 2013|