The investment portfolios of large super funds reflect managers' best ideas checked by the noise and frictions of the real world, write Parametric's Raewyn Williams and Hemambara Vadlamudi.
Those responsible for constructing investment portfolios have a choice. They can doggedly focus on these ideas and live with the implementation leakages; or they can better understand how implementation frictions impact their decisions and deliver a portfolio that optimally blends best ideas with implementation efficiency.
One high-profile area of implementation efficiency centres on how tax influences investment outcomes.
Superannuation funds are subject to tax on most investment earnings, and what builds wealth for members’ retirements are after-tax outcomes.
Earnings supporting transition-to-retirement pensions will be drawn into this after-tax world based on the recent federal budget 2016 superannuation changes.
It is a relatively simple mathematical exercise to take familiar investment concepts such as pre-tax portfolio returns, benchmark returns and ‘alpha’ (outperformance over benchmark) and extract the following key after-tax concepts:
The third of these concepts is especially important in answering the seminal question: ‘Is your alpha big enough to cover its taxes?’
Clearly ‘tax alpha’ is an influential component of performance outcomes, and should be recognised as a genuine lever in a fund's investment armoury.
The academic case for tax alpha may be clear, but it needs ‘street cred’ – to be understood in terms of how it can be harvested in practice and whether it can ‘move the dial’ for investment outcomes.
Opportunities to address tax leakage and pursue tax alpha abound because frictions occur daily in superannuation investment portfolios.
Tax alpha management techniques focus on funds' general preferences to pay a lower rather than higher rate of tax, receive higher rather than lower tax offsets and pay tax later rather than earlier.
The last of these can be likened to receiving a zero per cent interest loan from the ATO. Techniques to generate tax alpha (detailed in a research paper we recently released) include:
Like other forms of investment alpha, funds need to establish an investment risk budget to pursue tax alpha as a source of return.
The aim is to provide the tax-skilled manager with enough latitude to apply these skills for meaningful reward, but not so much that the pursuit of tax alpha risks giving up too much of the pre-tax alpha earned.
Lastly, we can show with a simulated portfolio (with a tax-efficient Centralised Portfolio Management structure and tax-skilled manager) the quantum and drivers of tax alpha to a taxable superannuation fund equity portfolio. Our key insights are:
Our research demonstrates that tax alpha is a persistent, predictable and harvestable source of investment returns.
It differs from other forms of investment alpha only in one important (and attractive) respect: it can generally be pursued on top of, rather than as a substitute for, other alpha sources.
This quality should excite superannuation funds because it does not require the fund to make a difficult binary decision between this source of alpha versus that source.
The fund can add the pursuit of tax alpha while retaining its existing sources of alpha, making tax alpha the “new recruit” to the alpha team.
Raewyn Williams is Parametric’s director of research, after-tax solutions. Hemambara Vadlamudi is Parametric’s director of research, algorithm development.
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