Tax efficiency is an interesting statistic, but the real statistic of importance is performance after-tax. This depends on a variety of factors, three of which are: the average holding period for trades that attract long-term capital gains, the proportion of gains that involve short-term capital gains, and the pre-tax rate of return achieved.
Turnover attracting long-term CGT
The holding period is linked to turnover through an inverse relationship. As a consequence, as the table below shows, the impact of increasing fund turnover is much more dramatic at low turnover levels than it is at high levels. Increasing turnover from zero to 10 per cent (20 per cent) a year eliminates 59 per cent (79 per cent) of the saving in the present value of tax relative to a 100 per cent turnover. Index strategies incur between 10 per cent and 20 per cent turnover each year from index changes and corporate actions.
The actual amount of tax associated with any gain depends on the tax rate, and is clearly higher for investors facing long-term CGT rates of 23.25 per cent than for super funds facing 10 per cent. Also, CGT will be higher following periods of strong asset price growth, such as the past three years, than in periods of more normal asset price growth. The table illustrates that increasing turnovers above 30 per cent implies relatively little change in tax efficiency, so long as short-term gains are not incurred. The major impact occurs in moving from a complete buy-and-hold strategy to an index strategy.
As humans, we are incredibly poor at predicting what the world will look like long into the future. Hence, most buy-and-hold strategies are likely to have a low probability of achieving pre-tax success. However, there are occasions when CGT liabilities can be completely eliminated at some not too distant future point, such as when superannuation investors move into the pension phase, and on these occasions buy-and-hold strategies involving listed securities or exchange traded funds may be attractive.
Turnover attracting short-term CGT
Avoiding short-term gains permanently reduces CGT, while deferral of long-term gains only conveys a timing advantage. The CGT penalty on short-term gains is highest for individuals on the top marginal tax rate, increasing the CGT rate by 23.25 per cent (140 basis points each year for gains of 6 per cent a year). For superannuation funds, the CGT rate is increased by only 5 per cent (30 basis points each year for gains of 6 per cent a year). Hence, strategies targeted at high-income individuals must be much more careful about realising short-term gains than strategies designed for superannuation funds. Turnover and CGT strategies are obviously irrelevant for tax-exempt pension funds. In a relative sense, buy-and-hold strategies, index funds and exchange traded funds are more attractive to highly-taxed individuals than they are to superannuation and pension funds.
Turnover and pre-tax rates of return
Active management seeks to deliver higher pre-tax returns than equivalent buy-and-hold and index strategies. It almost goes without saying that active strategies that don't consistently achieve these higher pre-tax returns will destroy wealth, especially after transaction costs and taxes. Hence every active trade should be made in the expectation of earning higher returns after taking into account both transaction costs and taxes. Transaction costs involve explicit costs such as brokerage and also implicit costs such as the bid-ask spread and market impact. The taxes that arise from trading can be viewed in the same manner as a transaction cost, but it is a cost that varies according to whether the asset has been held for more or less than 12 months, when the security might be traded in the future if it is not traded now, whether the underlying investors are individuals, superannuation or pension funds, the level of unrealised gain involved and the existence or absence of realised capital losses in the fund.
If all investors were to reduce their trading in those securities whose prices had risen most significantly, the potential mis-pricing of these securities would offer higher pre-tax opportunities than the average security. Valuable information and insights have a limited life and delays in implementation can eliminate much of the potential gain. Hence turnover decisions depend on manager skill, the half-life of the information, the costs of trading and the tax factors raised above. The funds best placed to take advantage of information trades are those whose unit holders face low CGT rates, such as exempt pension funds and superannuation funds.
There are many other factors that affect the tax efficiency of managed funds. For example, those funds most effective at deferring gains in year one will start year two with a higher level of unrealised gains than a fund that realised more gains in year one. This makes it harder for tax-efficient funds to remain tax efficient. Past tax efficiency may not necessarily predict future tax efficiency. Finally, fund redemptions, trust deed provisions, tax lot accounting, tax loss harvesting and other factors can all have an impact.
The bottom line is that taxes matter and matter most to those funds with individuals on their unit register. Turnover, manager skill, buyback decisions, distribution policy, trust deed provisions and market history all affect a manager's ability to deliver superior performance after all fees and taxes. Those who are raising the tax debate will help investors make better decisions, so long as we don't exchange tax ignorance for overly simplistic heuristics.
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