Raewyn Williams

Superannuation funds moving to a rules-based equity management approach could improve their performance by more than half a percentage point a year by genuinely focusing on after-tax, not pre-tax, returns. The savings from an after-tax focus can be generated without changing the risk profile of the equities strategy.

New research by Raewyn Williams, Managing Director, Research (Australia), and Vassilii Nemtchinov, Director of Research, Equity Strategies, at the global implementation manager Parametric, tests its after-tax investing principles on the ‘fundamental indexing’ (RAFI) approach pioneered by the US firm Research Affiliates, which has only recently become directly available to super funds in Australia.

Parametric’s research finds that the appeal of fundamental indexing can be further enhanced by adopting a tax-managed RAFI approach and estimates the potential benefit to a super fund’s global developed equity portfolio to be 53 basis points a year, before fees and transaction costs.

Say Williams and Nemtchinov: “Since listed equities represent, on average, more than half of the entire investment assets of an APRA-regulated fund, this nascent opportunity to improve returns is highly significant. Consider the value of this additional 53 basis points a year to a super fund tasked with finding new investment ideas in a climate where markets are volatile, equities look fully priced, alpha is scarce and fee budgets are frugal.”
In Williams and Nemtchinov’s joint paper, “Fundamental Indexing: Why True Tax Efficiency Beats Simply Keeping Turnover Low”, they slam a “pervading misconception” at the heart of the active-passive investment debate – that simply moving from an active to more passive equity management style makes superannuation funds tax efficient.

“This is a false premise, failing to appreciate what the opportunity set to manage taxes on an equity portfolio really covers, and instead reduces tax efficiency to a simple, misleading ‘keep turnover low’ mantra. It is not about turnover minimisation, but about having turnover that recognises the asymmetric preferences of a taxable investor (less gain turnover, more loss turnover).”

“The opportunity to give a portfolio a tax holiday is ignored in ‘keep turnover low’ passive approaches but should be integral to the design of an equity portfolio based on after-tax principles.”

Modelling the differences between a tax-agnostic and a tax-managed RAFI global equities strategy from the perspective of a taxable super fund investor, the duo find that: “Over the 21 years of our analysis, a $5 billion RAFI global equity portfolio that simply ‘keeps turnover low’ grows to $24.6 billion, while its tax-efficient peer with a similar risk profile grows to $26.8 billion – more than $2 billion more – over the same period.”

Williams and Nemtchinov suggest that funds on the move towards a lower cost, rules-based approach to obtaining equity exposure should think about two kinds of differences between simply ‘keeping turnover low’ and a genuine after-tax investment focus: lost opportunities to add to after-tax returns (quantitative concerns) and visibility issues that prevent a super fund from assessing the portfolio’s performance and value in after-tax terms (qualitative concerns).

For Williams and Nemtchinov, there are very practical consequences of these differences: “The quantitative deficiencies of orthodox passive should inform a fund’s thinking around matters like the ability to meet investment objectives, rankings in peer surveys and APRA’s recently unveiled ‘heatmap’ rating of funds, which has some effective tax assumptions embedded in it. The qualitative deficiencies reflect on fiduciary alignment and the ability to manage stakeholder expectations. Both types of concerns are relevant to the member outcomes test that funds must now pass annually as a matter of law.”

Williams and Nemtchinov’s research concludes with a challenge to super funds to seize the opportunity to embed tax management into new rules-based equity approaches they are, in increasing numbers, adopting: “Our 21-year comparison with its $2 billion–plus difference is the cost of settling for the beguiling simplicity of a ‘keep turnover low’ argument instead of applying intellectual rigour to the after-tax question. Although not a cost that usually appears on performance reports, it is felt in other ways, including in super fund peer rankings, Productivity Commission reports, APRA ratings and, ultimately, in fund members’ pockets.”

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Martha Strebinger

Superannuation funds looking to deliberately tilt their Australian equity portfolios to maximise the benefits of franking credits need to address the significant risks inherent in such an investment approach, says the US fund manager, Parametric, in a new research paper titled “A Fresh Look At Franking”.

The paper highlights that franking credits can be a meaningful source of extra returns, but they “are not a free lunch”.

However, the authors, Raewyn Williams, Martha Strebinger, Vassilii Nemtchinov, and Travis Bohon, say there are certain steps that superannuation funds can implement to control the risks associated with a higher franking strategy.

“The research highlights that how a manager constructs the portfolio is critical.

“Fund managers can build better portfolios (given higher franking objectives) by moving from a simple screening portfolio construction process to a sophisticated optimisation approach.

“There’s also an important insight about customisation: A franking-aware fund manager with sophisticated optimisation skills can construct a finely-tuned portfolio that best reflects exactly what the superannuation fund wants.

“The superannuation fund can express its objectives and appetite in relation to matters like yield, tracking error, concentration, sector and style-factor risks, turnover and volatility.

“This still does not make franking credits a ‘free lunch’, but it does allow the fund manager to focus on delivering a set of higher-franking equity outcomes to a superannuation fund client’s exact dietary requirements.”

The research report says the importance of building better portfolios to derive the full benefits of franking credits is particularly relevant on an after-tax basis.

“From a pre-tax perspective, the superannuation fund investor is indifferent between the franked and unfranked dividends (in the paper’s hypothetical example, each security yields 5% and has an overall return of 8%), as shown below:

“An after-tax perspective, however, tells a different story: There is a clear preference for the fund to receive the franked rather than unfranked dividend, providing a yield of 6.07% (a 9.07% total return) for accumulation members and a yield of 7.14% (a 10.14% total return) for pension members. Both results outperform the unfranked dividend alternatives after tax.”

The authors say the hypothetical example showing the difference between pre-tax and after-tax returns of 1.82% (accumulation) and 2.14% (pension) is a principle worth highlighting in this low return environment. “Simply incorporating the value of franking credits in performance reporting results in a material uplift in absolute after-tax returns.

“What this means in a practical sense is that a superannuation fund’s Australian equity portfolio will, after tax, typically be making a bigger return contribution to the underlying member’s retirement goals than all the pre-tax performance reporting on the equity strategy would suggest.”

The report also identifies five trends in investment thinking that the authors predict will influence how higher-franking strategies are viewed by superannuation funds.

“The most high-profile trend is the industry’s development of CIPR (soon-to-be-renamed Comprehensive Income Product for Retirement) solutions for members in retirement phase. The risk-adjusted return case for a franking tilt is stronger for pension portfolios than for accumulation portfolios, which can add to a fund’s investment case to segregate pension from accumulation assets.

“Other investment trends influencing funds’ appetite for higher-franking strategies are after-tax investing, formal risk-adjusted return approaches, the rise of factor-based investing and re-defining ‘risk’ beyond the standard concept of benchmark-relative ‘tracking error’.

“All of these trends are likely to make funds more, rather than less, interested in higher-franking strategies like those presented in this research,” the authors say.

Read the detailed copy of the research report.

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