Originally published by Cuffelinks
For most Australian investors, tax can represent a meaningful performance drag. Large superannuation funds, facing a headline tax rate of 15%, may argue that this is only true for investors facing effective tax rates of 30%-49% (such as companies and higher net worth individuals). But our experience is that even a 15% taxpaying superannuation fund should care about the impact of tax on investment performance.
Why is after-tax measurement important?
Investing should not be dominated by tax considerations, and Australia’s tax laws, which generally prohibit strategies conducted with the dominant purpose of obtaining a tax benefit, reinforce this. US tax laws are different so investors should be careful using US research on this subject. However, the trade-off between seeking expected returns and the tax consequences of doing so should receive more attention than it does. The 2010 Cooper Report on the superannuation industry recognised this, and the Government responded by amending the superannuation law in 2013 to specifically compel APRA-regulated superannuation trustees to consider the tax consequences of their investment strategies.
With a few exceptions, this has not yet led to large superannuation funds integrating tax awareness into the way they invest. However, many funds are beginning this process by measuring the investment performance of their equity managers and strategies on an after-tax, not just pre-tax, basis. After-tax performance can give answers to two important questions:
‘Is my portfolio actually growing after tax?’ and ‘Is the tax on the extra turnover generated by my active managers, in trying to beat the market, eroding all my manager outperformance?’
Key requirement of accurate measurement
Measuring the success of equity strategies after tax is not as simple as it sounds, but it helps to apply these four key principles:
1. Ensure the after-tax calculation methodology reflects your actual tax profile.
For a superannuation fund, this means applying a tax rate of 15%, a capital gains tax discount of 1/3 (where applicable), capital/revenue offsetting restrictions and recognising the fund’s ability to claim franking credits (including a refund of excess credits) and foreign income tax offsets. Equities invested via unit trusts are unlikely to offer this because the fund pools the investments of investors with different tax profiles and usually provides standardised reporting to these investors. Discrete mandates (separately managed accounts) are therefore preferable.
2. Ensure the after-tax performances of the portfolio and the portfolio’s benchmark are calculated using the same methodology.
If the after-tax benchmark calculation uses a different methodology, then what looks like portfolio outperformance (or underperformance) could actually be a methodological issue. Specific questions to ask include: Are dividends treated as cash outflow or reinvested, pre- or post-tax? Is tax payable treated as a cash outflow on a monthly, quarterly, yearly or some other basis? How are off-market share buybacks (which sometimes deliver significant after-tax return benefits) treated in the after-tax performance calculation?
3. Use a ‘pre-liquidation’ rather than ‘post-liquidation’ calculation basis.
‘Pre-liquidation’ methods recognise only tax on income received, and gains and losses realised in the performance period, while ‘post-liquidation’ methods reduce performance for unrealised tax liabilities building up in the portfolio. Sometimes it is argued that large superannuation funds should use a post-liquidation methodology to align with their unit pricing (how they value the investment options that members can invest into or withdraw from). This is flawed thinking because the purpose of after-tax performance calculations is to record actual outcomes and encourage managers to be more tax efficient. While the purpose of member option pricing is to strike the price that is fairest, to both current and future assets and liabilities, and to both incoming and outgoing members. It makes sense for the performance calculation to recognise the value of a manager deferring tax compared to a manager creating a current tax liability in the same period. A pre-liquidation calculation will capture this difference.
4. Use a custom, rather than generic, after-tax benchmark.
The tax characteristics of an equity portfolio at inception can greatly influence the measured tax impacts of a manager’s investment strategy. The key characteristics are the inception date, the amount of embedded capital gains and losses in the portfolio at that time and the extent to which these gains are ‘long’ (qualifying for the capital gains tax discount) or ‘short’. A custom after-tax benchmark can mirror these characteristics, and the benchmark will also reflect continuous cash flows in the portfolio, which are outside of the manager’s control. This method is the fairest for managers and provides the most precise after-tax performance calculation for investors.
Our final suggestion is to learn what to read, and what not to read, from after-tax performance reporting. For example, an active equity strategy, which has a tax impact higher than a passive benchmark, is not a cause for concern (in fact, this outcome is quite natural). The right question to ask is whether the excess returns more than cover the tax payable generated by the active manager.