Research highlights super funds missing after-tax focus with factor investing

From

Raewyn Williams

New Parametric research highlights the misconception that factor investing is naturally tax efficient and identifies potentially significant tax drag associated with new factor strategies.

Research co-author, Parametric’s Seattle-based Chief Investment Officer, Paul Bouchey, says: “Factor investing is an area of great interest to funds, tying together key themes in the industry of fee pressures, appetite for transparency and scepticism about ‘alpha’. But we are concerned that all the research funds are seeing about factor approaches is pre-tax focused – effectively ‘rolling the tax dice’.

“We are known in Australia and the U.S. for our after-tax investment focus and want to show what tax insights can add to factor investing. Our research, based on a range of hypothetical factor portfolios, calculated tax leakage of between 64 and 86 basis points each year, which is at least 25% more than a simple market cap passive approach.”

Parametric’s research, which tested five single factor and two blended factor hypothetical portfolios, shows why there is high interest in equity factor investing, with all the portfolios examined beating a market cap portfolio on a pre-tax and post-tax basis. In Bouchey’s view, “these positive factor results are not surprising, but do reflect the same kinds of optimisation techniques we use to implement real factor portfolios, to efficiently target the desired factors and avoid unintended bets. A factor portfolio constructed without these techniques may not perform in the same way.”

Bouchey’s co-researcher, Parametric’s Managing Director of Research in Australia, Raewyn Williams, says the aim of the research is to not only show funds what factor strategies look like innately after tax – Parametric’s “rolling the tax dice” scenarios. According to Williams, “we wanted to show the benefits of ‘loading the tax dice’ in funds’ favour – that is, employing specific portfolio construction and tax management techniques to claw back some of the 64 to 86 basis points annual tax leakage in our hypothetical factor strategies.”

Williams adds: “Our research results are very encouraging to funds. In every case, we were able to reduce the tax drag in the factor strategy; in some cases, the tax drag was halved. Importantly, this is not done at the expense of the overall returns of the factor strategies.”

Parametric’s research has prompted the implementation specialist manager to formally launch its “Tax-Managed Factor Investing” capabilities for super funds in Australia. As at 31 July 2017, the manager was managing USD2.7 billion in factor strategies for U.S. clients, some with specific custom requirements, including an after-tax focus.

Bouchey, in Australia to meet with super funds and asset consultants, believes the time is right for an after-tax focused equity factor investing approach. “If funds are on the move to establish a new factor approach, why not make the move after-tax focused as well?”

Bouchey observes: “Our research shows how tax-managed factor investing can improve the case for a factor approach, adding an extra return source for the sponsor of this new idea. Clawing back some of the innate tax leakage could even be a way to finance a factor approach – if the tax clawback offsets the fee for the factor approach, then funds could target factor outperformance with no net of fees and taxes price impact to the fund in option-level unit prices.”

In light of the extra scrutiny APRA is giving some funds, Bouchey notes that “a tax-managed factor solution could also help show APRA that the fund is innovating and taking its legal responsibilities to have an after-tax investment focus seriously.”

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