Off-market share buybacks are a curious form of Australian corporate action – what rational investor deliberately elects to sell back shares at a price lower than market value? The answer lies in the after-tax value of the transaction.
A super fund investor goes backwards in pre-tax terms to go forward in after-tax terms. It seems logical, right? Perhaps not, with some super funds remaining wedded to pre-tax returns, despite the after-tax benefits to their members.
Our research of seven buybacks since October 2016 shows (before considering fees and transaction costs) that they collectively added over a quarter of a percent (28 basis points) after tax to superannuation funds holding the buyback stocks at index weight, and 1 per cent to an active strategy with a 10 per cent high-conviction overweight. It should be a no-brainer. But it costs funds in pre-tax performance to reap these benefits, so some choose not to participate.
Take Woolworths’ (WOW) April 2019 share buyback as an example. The pre-tax participation penalty increases linearly as the fund’s equity strategy becomes more active in nature and the overweight to WOW rises; held at index weight, the pre-tax penalty is three basis points; at 5 per cent overweight, it’s nine basis points; at 10 per cent overweight, it’s 15 basis points. Yet, the overall net-of-tax result vindicates the buyback strategy: for each strategy, after-tax performance improves by five basis points (index weight), 14 basis points (5 per cent overweight) and 23 basis points (10 per cent overweight) from this single transaction. Tax benefits driving this result are largely attributed to the effect of streaming franking credits to buyback participants, reaching as much as 39 basis points (10 per cent overweight) in our WOW analysis. And these after-tax performance enhancements multiply, as expected, as we consider all seven stocks in our analysis. In total, our high-conviction portfolio (10 per cent overweight all buyback stocks) pays a pre-tax “price” of over 3 per cent to gain a 1 per cent after-tax performance improvement.
These seemingly emphatic insights about the true value of buyback opportunities may, unfortunately, not be enough to drive the right member-centric behavior and decision-making by super funds, their equity managers and asset consultants. Why? Because most equity performance reporting for super funds focuses on pre-tax investment outcomes; important industry dialogue about investment opportunities, and the investment decisions made everyday by funds, continue to be anchored by pre-tax thinking. When funds and their advisers are selecting and appraising Australian equity managers (a decision with high stakes for all involved), they are always armed with pre-tax performance histories and rarely after-tax performance.
The implications of this pre-tax mindset are grave given our demonstration of how funds must “go backward” (take a pre-tax penalty) to “go forward” (reap significant after-tax return benefits). In our analysis, it requires courage for funds and their managers to give up anywhere from 78 basis points to 3.22 per cent in pre-tax performance, notwithstanding the significant value for fund members in doing so. There is, in fact, a perverse incentive to reject opportunities that add after-tax value to super fund members in order to preserve the pre-tax performance upon which so much decision-making is based – a classic agency risk problem.
A purist fix to this issue would be for the super industry to start again from “ground zero”, establishing after-tax performance as a baseline to reflect the taxable nature of super funds. This aligns funds’ investment thinking to what their most important stakeholders – members – care about. And it makes it easier for funds to comply with legislation that explicitly demands an after-tax investment focus.
A less ambitious fix, now accommodated by most custodians, is to remove (reverse) the buyback penalty from pre-tax performance whenever the strategy participates in a buyback. This manual process introduces risks but is manageable because buybacks are seasonal and sporadic. This practical fix is attractively simple. But its significant shortcomings include confusing users of performance reports, the inability to actually reward value accretion through buyback participation (not just avoid a penalty) and muddying the relationship with after-tax performance reporting. Really, this is a short-term solution that treats the symptom, not the cause.
Quite simply, the super industry’s pre-tax investment focus does a disservice to its most important stakeholders – fund members. The issues with this misalignment are writ large when buyback deals are on offer. The industry’s favored response – a performance “fudge” to pre-tax numbers – must evolve. Buyback participation should not require courage on the part of funds and their managers, nor should it require a manual performance workaround that clouds trust and understanding in how super fund equity performance is calculated.
Raewyn Williams, managing director, research – Parametric
Parametric Portfolio Associates® LLC (“Parametric”), headquartered in Seattle, Washington, is registered with the US Securities and Exchange Commission (“SEC”) as an investment adviser under the US Investment Advisers Act of 1940. Parametric is exempt from the requirement to hold an Australian financial services license under the Australian Corporations Act 2001 (Cth) in respect of the provision of financial services to wholesale clients as defined in the Corporations Act and the Australian Securities and Investments Commission’s Class Order 03/1100. SEC rules and regulations may differ from Australian law. Parametric is not a licensed tax agent or adviser in Australia and this does not represent tax advice. This material is intended for wholesale use only and is not intended for distribution to, nor should it be relied upon, by retail clients.
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