Raewyn Williams
Superannuation funds readjusting their investment portfolios need to carefully consider all the tax implications and not focus solely on timing and transaction costs, says global implementation specialist manager Parametric.
In a research paper titled “The Sting in the Transition Tail”, Parametric Managing Director of Research (Australia) Raewyn Williams and Analyst Joshua McKenzie use a modest hypothetical example of a small cash raising and transition of S&P/ASX 100 financial stocks to demonstrate that ignoring the tax consequences potentially costs the portfolio 13 bps – a leakage exceeding the transaction costs by more than six times.
Williams and McKenzie say: “Quite illogically, a traditional transition manager and underlying superannuation fund client could report that transaction costs have been contained well but remain blithely unaware of this much larger tax sting.
“As super funds are asked to constantly adjust and readjust their investment settings, the hidden cost of these tax-naïve transitions will add up and be felt in members’ pockets.
“The more super funds contemplate portfolio changes, the more they should be motivated to find a specialist platform to implement these changes to ensure that all the costs of their change program are managed well, including tax.
“A fund’s goal should be to extract as much value as possible from every new or necessary investment idea in its new target or destination portfolio, instead of seeing this value paid away to third-party brokers, traders, managers, funds and the taxman as the expensive price of getting there.”
The authors argue that although it’s business as usual for funds to regularly tailor their investment portfolios to adjust their liquidity, asset allocation, investment strategy mix and hedging and overlay settings, both the funds and their transition managers still have a blind spot around tax.
“When it’s considered that funds are liable to a 15% headline tax and can benefit from franking credits, it seems logical to assume that super funds would carefully consider the tax implications of any transaction involved in readjusting a portfolio. But this is usually not the case.”
To illustrate, they cite four examples where funds and transition managers need to be aware of the investment tax risks inherent in equity transitions:
- Selling out of cum-dividend legacy positions without considering the value of accrued franking credits not priced into equities;
- Selling out of ex-dividend legacy positions in a way that causes loss of franking credits received;
- Selling out of legacy positions before the trade qualifies for tax concessional treatment of capital gains;
- Allocating tax lots to the legacy trades which trigger higher capital gains or lower capital losses than other tax lots would have triggered.
Williams and McKenzie posit several techniques for consideration when addressing the tax risks involved in readjusting portfolios and note that these are standard considerations in a specialist implementation structure like Centralised Portfolio Management (CPM).
“Franking credits can be protected by managing the timing of ex-dividend and cum-dividend stocks; capital gains can be managed by delaying a transition of short-term holdings, intelligent tax lot selection and widening the tax lot optimisation universe. More broadly, sector and factor risk optimisation techniques can help to define the legacy and target portfolios in a transition based on risk characteristics.”
The new research also refers to an actual tax-aware equity transition conducted for a super fund client in March using Parametric’s innovative CPM model, which triggered around a quarter of the turnover and capital gains compared with a traditional approach to transition management.
The authors conclude: “Super funds may endorse the principle of tax awareness in their business-as-usual change environment, but tax-aware transition practice requires the right structure, operational processes, tax lot information and, of course, skills to balance tax thinking with the other important dimensions of transition management. Tax concerns should not drive how equity portfolio changes are implemented, but surely we can do better than just ignore tax costs completely.”
