Managed accounts score points with tax efficiency

Tax is one of the key drivers of the growth in managed accounts worldwide. Changes to the treatment of short-term and long-term capital gains introduced in 1989 in the United States, and 1999 in Australia, have fuelled demand for directly owned, professionally managed portfolios.

Tax is also a big issue for investors. Taxpayers in Australia reported capital gains of more than $55 billion in the three years to June 2000 and almost $20 billion in the 2000 fiscal year alone. Whether these capital gains are realised in the short or long-term results in a difference of around $5 billion in 2000 and $12 billion over the three year period.

Managed accounts work off the theory that since every investor is different, then their investment portfolio should be managed to reflect those differences. One of the key factors differentiating investors is their tax status. Looking at the various tax structures used by different investors highlights this issue (see table).

Charities and allocated pensions do not pay ordinary income or capital gains tax but do receive imputation credits on franked dividends. Other not-for-profit groups likewise do not pay tax, but do not receive the benefit of franking credits.

Superannuation funds on the other hand pay 15 per cent tax on income and receive franking credits, but pay tax on only two-thirds of long-term (more than 12 months) capital gains. Companies pay 30 per cent tax on all income and gains, while individuals pay up to 48.5 per cent tax on income but pay tax on only half of long-term gains.

Thus when a portfolio manager is faced with an investment that has components of unfranked income, franked income, capital return or tax-deferred income (such is the case with company buy-backs, property trust distributions and so forth), the after tax outcome will depend on the individual investor for whom the portfolio manager is making decisions. This differentiation is simply not possible in a unit trust environment.

Managed accounts allow the underlying investor to purchase securities directly in their own name, while retaining the key benefits of managed fund investment, namely professional management, diversification and liquidity.

The investor does not acquire units in a fund which has embedded capital gains, nor are they affected by the buying or selling of others.

If a managed fund is realising gains, either to satisfy redemption requests or via active management, the investor will share in the realised gains and pay tax on those gains, despite the fact the investor may not have sold any units.

Many managed funds have distributed sizeable taxable income payments to unit holders in recent years, despite suffering negative returns — the worst of both worlds.

Managed accounts do not suffer these drawbacks. Investors are only impacted by activity in their portfolio, not others. Investors can fund their managed account with existing securities, which may have embedded gains. Their portfolio manager can manage this to ensure that large unrealised gains are not realised.

Alternatively, investors may fund their managed accounts with cash, in which case securities are purchased directly into their portfolios and the cost base is established at the time of acquisition.

By owning securities directly in the portfolio, investors can take advantage of a number of management strategies which can enhance after-tax returns. One of the most powerful reasons to own investments directly is the ability this grants investors to manage the timing and management of taxable activity. Some of these strategies are outlined below.

Tax Lot Accounting— where a holding may have been acquired at different times and at different prices, the parcel of shares (or lot) which results in the lowest tax payable can be sold out first, resulting in a reduction in tax paid.

Sale of low basis position— an investor may have a large part of their wealth tied up in one stock which has a large embedded capital gain. The portfolio manager may liquidate part of the holding and diversify the position gradually over time to reduce the impact of a large one-off tax bill. Losses elsewhere in the portfolio may be used to offset some of the gains.

Tax Loss Realisation— a tax loss is effectively a free option, since its realisation can be used to offset gains elsewhere in the portfolio. Managed account investors can benefit by having their manager sell loss-making positions and building up a ‘pool’ of tax losses which will lower the overall tax payable on realised gains.

Margin loan against shareholding— investors with a large part of their portfolio in one stock may choose to borrow against the position and diversify the proceeds. The interest on this borrowing may be tax-deductible.

Grandfathering pre-1985 (Pre-CGT) investments— investments purchased prior to 1985 are free from capital gains tax when sold. Thus, the future return from such investments is effectively tax-free. These investments, assuming they stack up on investment fundamentals with similar investments, should generally continue to be held in the portfolio.

Manage the‘45-day rule’— in order to halt trading in franking credits, securities must generally be held at risk for a minimum of 45 days around the date of a dividend in order to receive the franking credit attached to that dividend. Portfolio managers need to ensure that they do not buy and sell a share around a dividend payment date which they have not held for 45 days.

Rebateable imputation credits— as previously mentioned, some investors can receive a refund from the tax office if the level of franking credits received is in excess of their taxable income. This has the impact of increasing the value of franked dividends by up to 40 per cent for some investors.

Managing taxable portfolios requires a constant trade off between a ‘known’ tax cost (the amount of tax paid/saved on the realisation of a gain/loss) and an ‘unknown’ change in portfolio utility (increase in expected return, reduction in expected risk or both).

Unless the portfolio manager is aware of the tax consequences of each trade for each portfolio, this trade-off is likely to result in a sub-optimal outcome for the end investor. In managed funds, the tax consequences of the end investor are never known. As a result, managed funds generally invest on a pre-tax basis — which does not always result in the best after-tax outcome for the investor.

Tax is one of the many benefits of managed account investing, benefits that will continue to see this type of investment growing strongly into the future.

Martin Crabb is the director ofMacquarie Private PortfolioManagement