Clearing the way for greater transparency

Since Australia marches in step with all things American these days, it’s inevitable that reaction to the launch of a legislative regime of after-tax reporting would be as controversial here as it was in the US.

In America, pent-up consumer demand for a move from pre to after-tax reporting was resisted strenuously over a number of years by certain types of fund managers.

They were reportedly fearful that after-tax reporting would highlight the fact there were a lot of tax costs associated with their high-turnover investment strategies.

Fed up with all the stalling, the US Securities and Exchange Commission (SEC) issued a ruling in 2001 that obligated the many thousands of mutual funds under its jurisdiction to disclose standardised post-tax returns.

This is not to suggest after-tax reporting by fund managers will become obligatory in Australia, or at least any time soon.

However, it has relevance to Australia in a sense that the methodology of the SEC is beginning to be embraced at the funds management level and also the research level in Australia.

At another level, the example of the SEC has served as something of a stimulus to demand for after-tax reporting by both investors and planners on behalf of their clients.

Growing demand in Australia is arguably most manifest in the formation of a working group by the Investment and Financial Services Association to develop a ‘guidance’ note for members on after-tax reporting (see box report p18 Money Management February 1, 2007).

In August last year, active fund manager MLC joined broadly index managers Vanguard Investments and Dimensional Fund Advisors in pioneering after-tax reporting investment returns for a number of its funds.

The three groups claim to have made the switch from the customary pre-tax reporting to give advisers a better understanding of what their clients will actually receive in the hand on an after-tax basis.

By way of example, one recent US study showed that when measured on an after-tax basis, tax aware investment strategies outperformed tax unaware strategies by more than two percentage points per year.

The three groups report tax returns both before and after redemption, as some funds may be very tax efficient while held by investors but they may result in significant capital gains tax once redeemed.

Post-redemption reporting assumes that at the end of an investment period unit/s in the fund are redeemed, and an investor pays tax on the redemption of the unit/s, while pre-redemption reporting looks at the tax effectiveness of a fund’s distributions.

Investors who buy and hold a fund are mostly concerned with how tax effective the distributions are from that fund.

Furthermore, research group Morningstar has just pioneered a post-tax performance ranking on managed funds in Australia, increasing the level of transparency of fund selection for planners on behalf of investors.

The ranking compares individual funds to see which are the most tax effective, and also compares how tax-effective a fund is against the ‘average’ fund (see Tables A and B, p19 Money Management February1, 2007).

Any planner using a Morningstar adviser workstation tool has access to that ranking, which currently comprises comparative after-tax returns on over 600 funds from around 30 managers.

The researcher is reportedly planning to increase the number of managed fund after-tax returns on the ranking to more than 2,500 funds once the full tax information for 2005-06 becomes publicly available for analysis.

This effectively means that planners are able to see the after-tax returns of a lot more fund managers than the three pioneering groups that choose to report it directly as part of their marketing collateral.

Morningstar has also produced a tax-cost ratio, which works similarly to a conventional MER to provide a measure of the tax effectiveness of income distributed by the fund.

It works on the basis that the higher the tax-cost ratio of a fund, the more tax you pay from that fund, ignoring whatever tax rate happens to apply to an investor in that fund.

A fund in the ranking would have a higher tax-cost ratio because a bigger part of the return is being passed on to the investor as a realised capital gain.

This offers an investor a straightforward method of comparing funds on the basis of a better after-tax outcome, rather than merely on the basis of their pre-tax returns.

The tax-cost ratio (and ranking) are among the “first steps to making after-tax reporting a constant in the Australian financial planning sector”, according to Anthony Serhan, Morningstar’s head of research.

He said after-tax reporting in Australia is currently being driven by two trends, one being the growth in the number of retirees, many of whom are living off the distribution of their investment.

“Along with extra focus on income these people are going to be more focused on the after-tax effect of their investment,” Serhan said.

A second driver is that both Morningstar as a researcher and a number of firms offering managed funds in Australia have a long history through affiliates of after-tax reporting in the US.

Serhan believes after-tax reporting in Australia is set to “grow rapidly from here on out”, but he acknowledges that managers that are “likely going to publish after-tax returns on their own products are the ones who have something to benefit from it”.

“It’s simply inevitable that when you introduce something of this nature that half the people involved will look better and half the people will look worse.”

On the other hand, he said there’s “plenty of managers who are happy to have us report after-tax returns, because they don’t have the resources to set up the algorithms to do the necessary calculation”.

By and large, however, Serhan believes every class of (managed fund) investor would benefit from after-tax reporting, although the value of the information will vary depending on an investor’s tax bracket.

The top marginal rate is where the greatest differential between pre-tax and after-tax reporting occurs, he said, but you “really have to get a pretty low tax rate for it not to be important to an investor”.

“For example, a super fund tax rate of 15 per cent is a lot less than the top marginal tax rate of 46.5 per cent, but the taxation for a super fund is still one of their largest expenses.”

Vanguard chief investment officer Eric Smith said that after-tax reporting is “not perfect, but it nevertheless offers a lot more information to fund investors than pre-tax reporting, which tells you nothing but the starting point”.

“And given that most of the (fund) returns we all get, with a few exceptions, are really the market anyway, tax efficiency is much more consistent as a measure because it’s a function of the nature of the way the manager operates.”

As an example of this consistency, Smith said a fund manager that churns more than 200 per cent of a portfolio a year is always going to deliver much lower after-tax returns than the pre-tax.

“By contrast, a fund manager who churns 3 per cent of a portfolio a year will always be a lot more tax efficient in terms of returns, relatively speaking.”

He said tax efficiency is a “lot like fees in the sense you know you are always going to pay a higher fee for an active than index manager — index funds being inherently tax efficient”.

Vanguard, as an index manager, “likes being reported after-tax because it highlights a proportion of the difference in the net return to investors that is the tax effect”, Smith said.

“This is due to two things, one being that we defer the realisation of capital gains for really quite extended periods, meaning our turnover is really low.

“On the other hand, even when we do turnover it is almost always the realisation of long-term rather than a short-term gain, so we get the discounting benefit.”

Smith said the difference in tax treatment is critical for the comparative outcome of an active management product and an index product, or even two actively managed products.

“If you’re losing an extra 1 or 2 per cent a year (over a longer-term measurement) because of tax inefficiency then the manager has to add that much value just to get you back to the starting gate.”

Andrew Cain, senior portfolio manager at Dimensional Fund Managers, prefers to speak in terms of an investment strategy being tax naïve or tax sensitive.

A tax-naïve strategy has a much higher churn than a tax sensitive strategy, he said, using Australian equity funds as an example.

“Those funds that will look better on after-tax performance will be low-turnover products that don’t generate a lot of realised capital gains that have become taxable.

“In particular, any sort of strategy that does a lot of short-term trading won’t do very well.”

By this definition, hedge funds, which are basically short-term trading funds, with most of their returns coming out as distributions, are going to probably be one of least tax-effective options.

Cain said Dimensional “manages its capital losses in ways we refer to as ‘harvesting’, where throughout the year we bank losses that may have occurred and are able to offset them against gains that are yet to be realised”.

“At the end of the year the accountants look at what has been realised by the fund in terms of gains and losses and they are able to offset one against the other.

“After this they are able to say if there is a distribution of a capital gain, and if there is, whether and what proportion are short-term and long-term.”

“And then there’s of course the income distribution as well, which is where the accountants determine the franking credit component.”

For David Hutchison, MLC investment research manager, hiring managers who do not churn a lot of stock is a more important determinant in delivering a good after-tax outcome than whether a manager’s investment style is active or passive.

“The hurdle these managers have to get over to deliver you a good after-tax outcome is a lot higher, and given the strength of the markets we are in that’s actually quite difficult to do.

“We use active managers, but these managers take tax into account in their investment decisions, in the sense they generally hold onto stock for 12 months at least to get the discount gains.

“This strategy also reduces the amount of transaction costs investors incur, which is another side benefit, although not obviously as big as the after tax benefit,” he said.

However, Hutchinson emphasised that tax considerations should not be the sole driver of investing, unlike investments that are promoted as tax aware, such as some plantation products.

“After tax investing is not about having tax as the sole investment consideration, but rather about building the most sensible strategy that will give you an after-tax return.

“The way we look at it is there are three types of investment, one that delivers a really good pre-tax return but tax inefficient, one that offers a really low pre-tax return but is really efficient.

“Then there is the investment in the middle, the investment you ideally want to be in, which is somewhat tax aware but ends up being the best after-tax outcome,” he said.