Australian Financial Review, Managed Funds Quarterly, Augsut 2008
Momentum is growing in the campaign for Australian mutual funds to report their returns on an after-tax basis.
Vanguard has long led this particular crusade, and arguably has a good reason to do so: passive managers like Vanguard tend to have very little turnover in their portfolios, which generally means a more favourable after-tax result than those funds that have regularly bought and sold positions, triggering capital gains. It remains a frequent commentator on after-tax reporting, arguing it brings greater transparency and allows for better-informed investment decisions.
With markets falling, the idea has gained a wider following. When markets are rising people are rarely worried about any slender additional costs caused by churn within a portfolio, but when they are falling, people pay much closer attention to what is costing them money.
An example of the momentum was a conference held in Sydney in July by the global specialist broker ITG, whose services include providing data, analytics and after-tax benchmarks to fund managers and superannuation funds. ITG’s Asia Pacific product manager Tania Castro, who says the conference got double the level of attendance she was expecting, argues fund managers who use tax management techniques to guide investment decisions can improve performance by up to 5%.
ITG has produced a publication on why after-tax approaches matter, spelling out several examples. The most obvious is the capital gains tax treatment of stock sales: if a super fund sells a stock within a year of buying it, it gets taxed at 15% on the gains, versus 10% if it is held for more than a year. Another example is share buybacks, which are often structured to include a large fully-franked dividend, the impact of which is much bigger when considered (and reported) on an after-tax basis. Indeed, there are instances where a manager aiming for good headline performance would be better off avoiding a buyback, when in fact the after-tax result would be better if they participated in it.
Traditionally, the argument against after-tax reporting has been that it is just too unwieldy to compare like with like. Everyone’s tax circumstances are different, and Australia features a range of different tax bands. This has tended to cause providers of industry rankings to dismiss the idea as too cumbersome.
But Castro says that although there will never be a one size fits all approach to this reporting, it is possible to come up with some useful after-tax benchmarks. Examples include an imputation index, which takes into account the impact of franking credits on dividends and buybacks; simplified tax rule indices, which consider the entire gain for a portfolio and then illustrate its performance after tax at a specified rate, offset against franking credits; and fully replicating benchmarks, which are calculated for individual managers by matching all the inflow, buyback, and tax methodologies of the fund.
An example of an active fund manager that not only uses after-tax techniques but requires its managers to measure performance against after-tax benchmarks is Warakirri Asset Management. Richard Friend, head of portfolio management with Warakirri, thinks super funds in particular are going to be keeping a keen eye on after-tax approaches and will award mandates accordingly. “Within two years, we expect the majority of super funds’ Australian equities investments will be via tax-aware mandates,” he says.
While the use of after-tax considerations in investment is likely to increase, we are still a long way away from groups like Mercer and Morningstar changing their regular performance tables to an after-tax basis. That said, Mercer does do some surveying of after-tax returns, and some super funds, including Vicsuper and Aussiesuper, report to their members on an after-tax basis. Nevertheless, manager comparison is difficult. “What we’re looking to say is for each manager, here is your benchmark, tell me how much alpha you produce,” says Castro.
It’s possible that a move to after-tax awareness will see new mutual funds (or individually managed accounts, which should benefit from this shift) managed for different groups according to their tax situation. We could see funds for high net worth individuals, where tax reduction will be a key consideration; then other funds for superannuation investors to go into, where the tax consideration is less. At the moment all these groups go into the same fund leaving managers with little idea of their tax position even if they were interested in it. “Unscrambling the eggs is the hard bit,” says Castro.
Castro says even the funds management industry sees this sort of reporting as inevitable. “One person at the conference was saying: I don’t like this, but I can see it’s going to happen,” she says. “It really is in the end client’s best interests.”