Shares in front after taxes and costs

It is tempting to write off shares as a viable investment given ongoing volatility in the market. Since the global financial crisis hit in 2008, Australian shares have been bouncing around, but basically going nowhere. The S&P/ASX200 index is still down about 40 per cent from its 2007 high and has fallen about 10 per cent since early May.

Dividends, which were little more than an after-thought for many investors during the bull market, have become the sole source of return for many investors, though generally have not been sufficient to offset falling share prices.

The rough ride is likely to continue as Western economies work out the over-leveraging that occurred during the boom, but shares still offer advantages that safer investments like cash don't.

Russell Investments' latest Long-Term Investing Report found Australian shares were the top-performing investment class on an after-tax basis over the past 20 years, returning between 7 per cent and 9 per cent a year, depending on your tax rate. (It also calculates all returns after costs.) By contrast, residential property returned between 6.6 per cent and 8.1 per cent, bonds between 3.9 per cent and 6.1 per cent, and cash a mere 2.1 per cent to 3.3 per cent.

The report is interesting in that it looks beyond the headline numbers of pure investment returns to what really matters: how much investors actually put in their pockets after tax. As anyone who has received a managed fund distribution only to be hit with a big capital gains tax bill can attest, you can't spend or reinvest profits that have to be paid to the taxman.

The report looks at both the before- and after-tax returns of the main types of investments that individuals and their super funds are likely to hold: Australian shares, residential investment property, listed property, bonds, cash, overseas shares (both hedged for currency movements and unhedged) and overseas listed property. It is a long-term view and consequently doesn't reflect the experience of someone who bought shares at the top of the market. It is also a historical study, and as we all know, past returns are not the best guide to the future. But it does offer some interesting lessons for investors. The main lesson is how critical it is to focus on after-tax returns rather than those before tax.

Australian shares did not provide the highest headline returns over the past 20 years. That distinction went to residential property, which returned 8 per cent a year over the past 10 years and 9 per cent over the 20 years to December 31 last year. Australian shares had pre-tax returns of 6.1 per cent and 8.7 per cent over the same time periods. Australian shares actually ran third over the past 10 years, with bonds returning 6.4 per cent a year for the decade. But both property and shares have tax advantages bonds don't. And shares, it seems, have a further tax advantage over property.

For someone on the top marginal tax rate, the effective tax rate paid on share returns over the past 20 years was just 20 per cent. Only bonds and cash were taxed at the full rate of 49 per cent. The effective tax rate on other investments was:

Australian listed property - 23 per cent.

Residential investment property - 26 per cent.

Overseas shares - 28 per cent.

Global listed property - 36 per cent.

And it's not just higher earners who benefit. As Russell points out, such is the power of franking credits in increasing after-tax returns that for investors on lower tax rates (including superannuation funds), the after-tax return on Australian shares is higher than what they get before tax.

So over the past 20 years, while Australian shares may have returned 8.7 per cent, a low marginal-rate taxpayer would have received an after-tax return of 9 per cent, and a super fund 9.2 per cent. None of the other investments offered this ability to actually earn higher returns on an after-tax basis.

While super funds only receive a one-third discount on capital gains (as opposed to 50 per cent for investments held by individuals), the report found both high and low earners increased their after-tax returns by holding shares through super. The report also looks at gearing and how it affects returns. When gearing is included, the returns from both residential property and Australian shares were higher.

Geared residential property did better over the past 10 years (8.3 per cent after tax for someone on the lowest tax rate versus 6.5 per cent for shares 7.4 per cent versus 4.9 per cent for a top rate taxpayer). But over the past 20 years the tables were turned, with geared shares returning 10 per cent a year for someone on the lowest tax rate (8.7 per cent for property) and 8.3 per cent (versus 7.8 per cent for property) for someone on the highest tax rate.

Of course, in a prolonged bear market or period of high interest rates, gearing would be just as effective in increasing losses.

But the report does present a compelling case for looking beyond mere market returns. Tax is a fact of life and should be taken into account when deciding on the best investment strategy.

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