Buybacks show why you can’t trust the numbers

From
Raewyn Williams

Raewyn Williams

Australia’s recent spate of off-market share buybacks highlights the misalignment between super funds’ pre-tax investment focus and what matters to fund members – after-tax returns.

This is the view of global implementation manager Parametric in new research that graphically illustrates that funds participating in these share buybacks must ‘step backwards’ in pre-tax returns to ‘step forward’ in after-tax returns.

The authors, Australian Managing Director, Research, Raewyn Williams, and Analyst, Josh McKenzie, who looked at seven prominent buybacks on the market between 2016 and 2019, say: “The figures tell all. In pre-tax terms (before fees and transaction costs), an index-tracking fund ‘steps backwards’ by 78 basis points across all buyback stocks. But after-tax terms, it ‘steps forward’ 28 basis points. If a super fund is overweight five or 10 per cent to these buyback stocks, the pre-tax penalty is higher but the performance gain is 64 basis points and 100 basis points, respectively, after tax.

“What we are saying is that performance-wise super funds have to go backwards in pre-tax terms to go forward in after-tax terms. It is the investment version of Roald Dahl’s ‘square sweets that look round’ – it makes perfect sense when you understand it.”

The authors step through the mathematics around buyback calculations to dispel confusion about how buyback participation impacts equity portfolio performance and demonstrate the true value of buyback opportunities for super funds. “But a critical question remains – is this enough to drive the right member-centric behavior and decision-making by funds, their equity managers and asset consultants?

“Most performance reporting on Australian equity strategies for super funds focuses on pre-tax investment outcomes. So, when funds and their advisers are selecting and appraising Australian equity managers (a decision with high stakes for all involved), they are always armed with pre-tax performance histories and rarely with after-tax performance.

“The implications of this pre-tax mindset are grave given our demonstration of how funds must ‘go backward’ pre-tax to ‘go forward’ after tax. In our analysis, it becomes very difficult for funds to give up as much as 3% in pre-tax performance, notwithstanding the significant after-tax value to be generated for members in doing so.

“There is, in fact, a perverse incentive to reject opportunities that add (after-tax) value to superannuation fund members in order to preserve the pre-tax performance upon which so much decision-making is based.”

Williams and McKenzie say there are two ways in which the industry can solve this problem – a sustainable solution that eliminates the agency risk and addresses the misalignment in investment focus and a “quick fix” that requires what the authors call a “performance fudge” to specifically deal with buyback scenarios.

“If the industry could reset from the ‘ground up’, one compelling idea would be to establish after-tax performance as the baseline to reflect the taxable nature of super funds. This would align funds’ investment thinking to what actually builds retirement savings for fund members – after-tax returns. There are other motivators as well, like improving the fund’s ranking in peer surveys and beating the effective tax assumptions embedded in APRA’s new heat map.

“A less ambitious, and more common, fix is to back out the buyback impact from pre-tax performance whenever the strategy participates in a buyback. This removes the perverse incentive for an equity manager to reject a value-accretive buyback opportunity by eliminating the pre-tax buyback penalty.”

The Williams-McKenzie paper identifies problems with this quick fix and stresses that it is only a short-term solution for funds. “We need to address the issues with this approach – have funds thought about them? This quick fix has been a helpful start, and it’s great that custodians can accommodate it. But it should be just a stepping-stone to a more sustainable, long-term equity solution that genuinely transitions super funds to an after-tax performance mindset.”

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