After-tax returns: the big letdown

How many times has it happened? You know the market has been strong, you know your fund manager has performed well. Then you get your after-tax returns from the fund and the figure is way below the headline figures reported in the fund and by the financial press.

What went wrong? You've just hit the after-tax gap '” the difference between the pre-tax headline number reported by the fund and the “take home” number that goes into your bank account.

In contrast to the US, Australian managed funds only report pre-tax performance figures, a vague and sometimes misleading indication of “take home” returns. However, things may be about to change if Jeremy Duffield, the chief executive of Vanguard Investments Australia, has his way. Duffield has been researching the fund market and pushing for change; already the fund rating agency MorningStar has begun to publish a limited selection of after-tax returns.

Duffield says there is generally a gap of about 3% between pre-tax returns and the after-tax returns, which makes a big difference to investors.

So what can be done? The worst offenders in the market are the high-churn active managed funds, which buy and sell shares relentlessly searching for extra profit. The problem is that short-term trades (of less than 12 months) get hit big time for capital gains tax. The CGT is then passed on to investors.

As Duffield explains in today's video interview, on average fund managers hold stocks for just over a year but many trade more often. As Duffield suggests, the may to make money (and pay less tax) is to seek managers who buy the best stocks and don't have to sell them shortly afterwards.

The interview

James Kirby: Jeremy, at Vanguard you’ve been doing some research on the reason why after-tax returns from managed funds seem to lag the big numbers we see in the headlines. What have you found out?

Jeremy Duffield: Yeah, what really counts to investors is what they keep in their pockets, and the truth of the situation is that what investors keep after they pay their taxes is less than what they’re going to get quoted on a pre-tax return basis. So we think it’s really important that investment managers start reporting on an after-tax basis.

So are you saying that in only reporting these pre-tax returns, the managed funds industry is concealing something?

Look they don’t tell the whole story, really. I mean what really counts to an investor in management is what’s the component of return. How much of it is capital gains '” how much of it is long-term capital gains versus short-term capital gains; how much of it is dividend or interest income; and, particularly for dividends, how much is franked dividends? Very important to a taxable investor.

Could you explain why these items make such a difference?

Sure. In Australia clearly the Government taxes different elements of return at differential rates, so that interest is taxed at the highest possible rates; long-term capital gains are taxed at half the rate of marginal tax rate and short-term gains are taxed like interest, at the full taxable rate. Beyond that, franking credits are obviously really valuable to Australian taxable investors because we get a credit for '¦ the tax is paid on behalf of us by the corporation.

So the outstanding issue is managed funds trading shares too often. Have you any idea, on average, how long managed funds hang on to stocks for ?

You’ve hit the issue on the head, James. Basically, it’s how long investment managers hold stocks that really makes the difference. You want your managers to avoid short-term capital gains if they can because you don’t want to receive short-term capital gains distributions. On average, fund managers probably hold just over a year, but there are some fund managers who are completely oblivious to how quickly they turn over their portfolio and the number they hold for less than a year, so they’ll be realising short-term capital gains all the time.

Recently on Eureka Report we had a fund manager, Anthony Starkins of First Samuel, who estimated that for a fund manager to genuinely match the index would have to make the index plus 3% to offset these tax issues. What do you think of that number?

I think that’s probably a reasonable estimate for a full top-rate marginal taxpayer. It would be less for a DIY super investor but still you’d have to earn half a percent or one percent to overcome the tax impacts and then there’s always the cost of the managed funds as well.

Of course, not everyone wants to run their own DIY fund. What can be done to stamp out this excess trading by managed funds?

I think they should realise that in general buy and hold or low turnover rate strategies have an after-tax advantage compared to really high actively managed strategies '” high turnover, actively managed strategies. So if an investor thinks about that issue when they’re selecting managers, they are likely to get a better result. Index funds, in particular, turn out to be buy-and-hold, low-turnover strategies that can do quite well on an after-tax basis.

Jeremy, what is stopping all the managed funds from reporting after-tax returns?

Well, I think that they’re concerned that they may confuse the investor by providing one more additional source of information. However, I think it may not be in their self-interest to present the data. It may show that their performance isn’t quite as good as it looks on a pre-tax basis, so I think there’s some self-interest in the issue as well.

Now, of course, this line of inquiry leads us to consider index funds but a question I have for you as head of Vanguard Australia is why Australian investors at Vanguard must pay so much more in fees than would be charged in America to retail investors?

I think the gap relates to the size of the markets. The American fund industry is so large '” it’s over $US10 trillion. Competition and economies of scale have really driven down the costs. Here in Australia the market’s smaller, index funds are still a very new concept and so we’d expect cost of indexed funds to come down over time, but they still offer about a 1% advantage over the traditional active fund and that’s about the margin in the US as well. So on a relative parity basis, I think they stack up pretty well.

And one last thing, Jeremy. We pay so much attention to fees '¦ is it possible that in the end taxes are more important?

I think they’re both important. I think for a high tax bracket investor, actually taxes could be more important. Fees are always important for everybody, but a marginal tax rate person in the 46.5% tax bracket really has to be careful about the tax issues. A super fund investor can be less concerned but they’re still going to think about tax when they think about whether they should be in bonds or shares '¦ whether they should invest with a high-turnover manager or low-turnover manager.