This is the second of three articles on the tax effectiveness of managed funds. The first addressed fund distributions ( IFA 347). It showed that simply comparing distributions versus unit price growth across funds can provide a misleading view of a fund’s tax effectiveness. This article addresses funds’ participation in share buybacks and the third article in the series will look at fund turnover.
Share buybacks are thought to offer a simple indicator of the extent to which managed funds focus on after-tax performance. This is because the buyback occurs at below the current market price, leading to a drop in pre-tax performance for participating funds. The franking credits obtained through the buyback increase the aftertax performance, but this is not reported in most performance tables and fund rankings. Hence the buyback seems to pose a simple conflictof- interest between those of the fund manager (aligned around pre-tax performance) and the investor (aligned around after-tax performance).
The simple analysis proceeds as follows. Suppose a share with a current market price of $10 proposes a $9 buyback price, made up of a franked dividend of $4.70 (this would imply franking credits of $2.01) and a capital component of $4.30. The after-tax value of the franked dividend to various classes of investors is found in table 1. To this must be added the $4.30 capital component and the capital gains tax (CGT) implications of the buyback. Suppose the shares were originally purchased at $10, the current share price. Then participation in the buyback will result in the realisation of a capital loss of $5.70 ($10 – $4.30). To funds that can set the capital loss against other short-term capital gains, the value to their investors of the $4.30 capital plus a capital loss of $5.70 is found in table 2. The after-tax value of the buyback is simply the total after-tax value of the dividend and capital components.
This can be compared with selling the share prior to the buyback, which is $10 for all investors, assuming that the purchase price of the shares is $10 (that is, no CGT). The net advantage varies across investors. All funds with only Australian unit holders should participate in buybacks based on these facts.
FACTORS THAT REDUCE OR ELIMINATE THE BENEFIT OF PARTICIPATING IN BUYBACKS
. Funds that can only use the capital loss to set against long-term gains (typically the case for index funds and funds with buy-and-hold strategies). The after-tax value of a capital loss of $5.70 to their individual investors is reduced from $2.65 (46.5%*$5.70) to $1.33 (23.25%*$5.70), turning the after-tax benefit of $0.54 above to a loss of $0.78. This indicates that investors in the top marginal tax bracket in index funds and funds with buy-and-hold strategies would be harmed if these funds participate in a buyback with these characteristics.
. Share prices tend to rise after a buyback. The company buys back shares at below the current market price and reduces the issued capital, driving up the value of the remaining shares. In addition, the actions of investors buying back in can further push up prices. Hence, the proper comparison to participating in the buyback is not the (known) market price prior to the buyback, but the (unknown) market price after the buyback. Non-participants in the buyback benefit from the actions of those that do participate. The greater the price rise, the lower the after-tax benefit to participating funds.
. Funds that want to participate in the buyback but not decrease their shareholding must repurchase the shares after the buyback. These funds pay transaction costs and risk being out of the market for a period during which time the share price may change due to new information. Investment knowledge regarding the company, beyond the buyback considerations, helps make an informed decision in this regard. A sufficiently high repurchase price can cause unit holders to suffer both an after-tax loss and pre-tax loss relative to unit holders in non-participating funds.
. The buyback price generally involves an auction. The typical discount starts at 10 per cent and can go to 15 per cent. The lower the price bid, the greater the probability the bid will be accepted but the lower the after-tax benefit. An aggressive bid may capture a higher after-tax benefit if it is accepted, but an aggressive bid has a lower probability of acceptance. Other complications are that instructions must be sent to custodians well before the cut-off date and proceeds from the buyback are not immediately received.
. Finally, the lower the fund’s original cost price of the shares the less the after-tax benefit of the buyback to all taxable investors in the fund. Hence, do managed funds, with multiple classes of investors as unit holders, participate too little in buybacks because all they care about is pretax performance? Undoubtedly some do, but this is not the general reason. The main reason is that buybacks are not necessarily an after-tax ‘free-lunch’ for everyone as they appear from a simple analysis. The outcome depends on the classes of investor in the fund, the fund’s CGT circumstances, the buyback auction price, the unknown price after the buyback and a host of other investment issues affecting the company.
