Tax-efficient investing

In a complex and busy world, we need to remind ourselves that sometimes it’s the little things that

make the biggest difference.

Let’s say we purchase one coffee each day during the working week, which means: $4.50 x 5 = $22.50 a

week on coffee. We work 48 weeks a year (we all need a holiday, I have factored in four weeks off a year) so that equates to $1,080 a year on coffee! Want to increase your holiday budget by $500? Simply cut down your coffees to two or three a week.

The same runs true for investing in shares – the simple things, such as understanding the tax implications of the different investment products (shares, managed funds, exchange-traded funds [ETFs] etc.) and the impact of portfolio turnover, will make the biggest difference to investor returns. In a low growth, low interest rate environment a focus on tax efficient investing is vital.

Investment products

In today’s marketplace investors have a broad range of products they can use to invest in shares – from direct shares to managed funds, ETFs and in more recent years, managed accounts. While each product will give the investor the desired exposure to Australian shares, there is a dramatic difference on the impact of tax and tax efficiency across each structure.

On one end of the scale you have direct shares. This is your traditional stockbroking account where the investor holds the assets directly on HIN (holder identification number). The direct ownership is the most tax efficient structure for investing in shares.

The investor is taxed according to their own circumstances with dividends and franking credits paid

directly to them.

The investor also has the control to tailor the portfolio for specific tax outcomes such as best utilising capital gains and losses and being able to participate in share buybacks. The Rio Tinto share buyback earlier this year consisted of a fully franked dividend of $39 per share! A great win, particularly for SMSF investors.

On the other end of the scale you have managed funds and ETFs.

These are unitised structures where the investor owns a unit in the trust, not the underlying shares. The tax impact is significant. Investors in this structure are bound to the capital gain liabilities held within the fund. These liabilities can be passed through to the end investor, regardless of whether they themselves have benefited from the capital gain. It is not uncommon for new fund investors to be hit with a tax bill only months after making their investment.

When it comes to dividends and franking credits these are collected by the fund and paid as distributions at the discretion of the fund manager. As we witnessed during the GFC many funds stopped paying distributions leaving investors without any dividend income.

On top of that many funds locked their redemptions, leaving investors with no income and no ability to exit their investment. Investors also lose control of their investment, because unlike shares they cannot tailor their portfolio for specific tax outcomes and they will not be able to participate in corporate actions such as share buybacks.

It is not all doom and gloom – the upside for investors with managed funds is their simplicity. There is no paperwork and the investor has a professional manager looking after their investment.

In the middle of the scale is the rapidly growing managed account structure. Managed accounts combine professional investment management and simplicity of managed funds, with the tax efficiency and transparency of a direct share portfolio. Managed accounts effectively provide the best of both worlds. For investors, direct shares and managed accounts provide a superior tax structure for investing in shares. A simple adjustment to investing in these types of products will have a huge impact on the investors after-tax returns.

Other benefits of going direct include the liquidity – you cannot underestimate the importance of having the ability to ‘cash’ out your investment especially during periods of market or personal turmoil.

The impact of turnover

We have considered product structure. Let’s now look at the impact of turnover on after-tax returns. In 2011 Towers Watson released a report entitled After-tax Investing in Australian Shares, which examined the level of tax drag created on an investor’s portfolio by turnover – tax drag being the reduction of investment returns due to tax.

The results are significant for investors. Towers Watson determined an average active manager who is tax unaware to have an average turnover of 75 per cent.

The tax drag for individual investors over a 20-year time frame on a portfolio turnover of 75 per cent is

0.41 per cent per annum.

Even when you factor in tax efficient holding structures such as superannuation, the impact is 0.21 per cent per annum.

It’s important to understand that these results are based on all tax being concessional in nature – a rather generous assumption!

Obviously these results understate the impact of tax because a large portion of these gains will be held for less than a year. To better understand the impact of tax, the Tower Watson report relaxed this assumption and added in different categories of managers – tax efficient, tax average and tax inefficient. As you can image, this greatly increased the tax-drag impact. For example, an individual investor with a tax-inefficient manager can suffer tax drag over a 10-year period of an additional 1.56 per cent per annum.

To fully appreciate this impact it’s worth considering the numbers in dollar values. For simplicity sake, let’s assume an investment of $200,000 in Australian shares over a timeframe of 20 years. We have assumed the long-term rate of return of 9.5 per cent as per the Russell Investments/ASX 2015 Long-term Investing Report. The picture is clear – high turnover has a significant impact on investors’ after-tax returns.

Tax-efficient investing

The conclusion for investors is that they need to shift their focus to low-cost, low-turnover investment strategies.

The allure of active investment management is compelling and you may think, ‘Well, I am happy to give up a little bit in tax if I can greatly increase my returns’. Unfortunately the evidence** is damning in showing that most investors, both amateur and professional, who are chasing greater than market returns end up significantly underperforming the market. Investors who remain invested for the long term have vastly improved returns. Long-term investing of course goes hand in hand with low turnover.

Investors who focus on low-cost, low-turnover investments held in a direct structure will greatly increase their after tax returns. In the current low-growth, low-return environment, this increase is amplified.