Tax shroud keeps investors in dark

Most fund investors are not shown their returns after-tax … and it’s time they were.

PORTFOLIO POINT: Investors would be well served if the managed fund industry were to provide one more piece of information – after-tax returns for investors.

There are numerous faults with the financial services industry, including low entry levels of educational requirements for participants, the structural corruption of financial service product providers also being in the business of giving advice, and the possible impact of commissions on advice quality.

But one fault that exists which could be fixed tomorrow by regulators is the lack of reporting of after-tax returns for managed funds.

This is information that any investor is entitled to, allowing them to answer the important question – how well has my fund done at increasing my wealth after taking into account the impact of tax?

After all, returns quoted without respect to tax are interesting. But tax is a reality of life for all investors (including investors with a 0% tax rate), so after-tax returns are much more useful.

It is not difficult for fund managers to produce this information. Sure, there are a number of tax brackets, however it is a relatively simple calculation for each tax bracket that could then be reported to investors. However, the poor record of tax inefficiency by managed funds - seen through big distributions to investors – is one reason some might be reluctant.

Fund managers that do report after-tax returns – such as Vanguard and Dimensional Fund Advisors – seem to have no problems in providing this information to investors.

To consider the possible impacts of tax on returns, let’s take two of the extraordinarily well-performed funds of the last 20 years or so – Hunter Hall Value Growth Trust and Platinum International.

The Hunter Hall Value Growth Fund started in May 1994, more than 18 years ago. Since then it has reported a return of 12.7% a year (to the end of September, 2012) – an extraordinary track record. Investors who have used Hunter Hall as part of their portfolio, especially if they used it as an international investment where it has outperformed the MSCI World Index by nearly 9% a year, would be thrilled.

An investment in the Hunter Hall Value Growth Trust has increased more than eight-fold over that period. However the unit price for the Hunter Hall Value Growth Trust has not increased so spectacularly – in 1994 it started at $1, and is now valued at $2.05.

This is not a bad effort – investors have doubled their money by the growth in unit prices over an 18-year period. But it leaves a lot of the return to come in the form of distributions. Indeed, over this period, $3.37 has been distributed to investors. Investors who were invested on day one of the forming of the Hunter Hall Value Growth Trust have received $1.05 (24%) of their return in capital growth and $3.37 (76%) in distributions.

The Platinum International Fund is another star managed fund performer.  It started at the end of April 1994 with a unit price of $1. The unit price is now $1.34. The return since it started (to the end of September 2012) is an impressive 11.55% per annum.  But this has been almost exclusively through distributions.

The problem with distributions is that they are immediately exposed to possible tax. Whether the distributions include some franking credits (which might even increase the total returns for some investors), foreign tax credits, offsets from capital gains in previous years and discounted capital gains, they usually create a tax bill for the investor.

Generally you would expect up to 50% of returns from investing in shares to come from dividends (say 4%-5% a year), and the rest (say 5%-8% a year) to come from capital growth. The returns that come from capital growth have the benefit of not being taxed until the shares are sold.

The often forgotten part of distributions from managed funds is the distribution of capital gains. Capital gains in a fund are generated from the share trading of the fund. The trading of a fund might be independent of any decisions of the fund manager – for example parcels of shares might have to be sold to pay for the redemptions of investments from the fund by other unit holders. If these shares are sold at a gain, then a distribution of taxable capital gains is made to investors. In contrast, investors who directly control their own portfolio have the ability to be strategic around capital gains decisions and the amount of capital gains tax paid.

If a managed fund investing in shares is going to create capital gains, it is far better to see this through an increase in the unit price of the managed fund, which is not taxable until the units are sold, rather than a distribution of capital gains that are then taxable.

Another trap of large distributions by a managed fund of capital gains from trading is that investors who wanting to live of the returns from their investments can find it difficult to understand how much of a distribution is true income from their investment, and how much is the distribution of capital gains from trading activities.

Platinum International and the Hunter Hall Value Growth Trust are two funds with strong long-term records, and even given that the significant majority of returns came from distributions (part of which would have had tax advantages such as imputation credits, foreign tax credits and discounted capital gains), they would have served investors very well. We know, however, that the majority of managed funds fail to perform as well as the simple sharemarket index.

For investors in these funds that fail to match the average market return, or seem to just beat it prior to considering tax, after-tax returns are crucial for investors to understand the actual return they get after the reality of tax.

And all investors need to be well armed with this information, meaning that funds should be forced to report after-tax returns. It’s a relatively simple calculation, communicated in a table with the different tax rates, and suddenly investors would have a crucial nugget of information at their fingertips – information far more important than the ‘pre-tax returns’ they are quoted now.


Scott Francis is a personal finance commentator, and previously worked as an independent financial advisor. 

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