T10 Tax and Portfolio Management Flashcards
What is the main argument supporting integration of tax-efficient strategies into investment management? Which aspects of the investment management process should factor in explicit tax considerations?
Tax-efficient investment strategies reflect a manager’s skills as part of investment management process. and can substantially enhance investment Rs and generate alpha. Tax inefficiency not only reflects that manager has inadequate skills but also costs investors more money than management fees; clients’ growing demand for after-tax performance measureing and reporting services, plus increasing industry spotlight on tax-efficient investment funds, dictate that funds should adopt tax-efficient investment management to remain competitive.
Explicit consideration of tax implications should be in AA, pf construction, stock valuation, trading/rebalancing and performance measurement.
Why hasn’t tax efficiency/After-tax Rs been a focus for managers and investors?
Because:
- Diff tax rates apply to diff investors
- No obligation to report after-tax Rs
- investors underappreciate benefits of active tax management; difficulty in understanding (and/or implementing) tax-efficient strategies
- potential misalignment of interests b/w inv manager and investors e.g. mgr may perform AAA to seek active Rs but investors may wish to retain certain positions for discounted CGT
- No integration of after-tax consequences into mgr and custodial systems
- lack of knowledge of after-tax benchmarks
However there is a growing appreciation of after-tax investing, performance measurement and reporting services
What is the investment manager’s overall responsibility when making decisions in relation to tax considerations?
Overall, investment decisions should NOT be tax-driven. Instead, tax considerations should be an integral part of the investment process. The manager doesn’t necessarily aim to minimise tax but rather maximise After-Tax Rs based on the investor’s marginal tax rate.
What are the after-tax investing principles an investment manager should apply when maximising the after-tax performance of investments?
- Policy - duties of APRA-regulated superannuation trustees; have go manage members’ interests with tax considerations and provide outcome that is net of fees, costs and taxes; performance fees must be calc based on after-tax basis; be prepared to provide docs that articulate how tax considerations have been integrated into inv decisions
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Divs, FCs and foreign income tax offsets -
- 75% FC = 75% x $div (corp tax rate)/(1-corp tax rate) ; your tax bill = your marginal tax rate x (div + fc paid to you by coy), your tax bill may be more than covered by the FC payment or partially covered by the FC payment.
- Generally the more the FC rate, the more you save on tax you have to pay on div income. investors with the lower marg tax rate (pension funds/charities with 0% tax rate) don’t pay income tax but are able to claim FC from the ato;
- w.r.t. international equity pf, foreign div income received is net of withholding tax deduction of around 15%, aussie investors when filing aussie tax return can usually claim this withholding tax back (as foreign income tax offset); but sometimes limited by investment scenario, so mgr must be aware of how assumptions around witholding tax in international equities benchmark affect performance measurement of intl equities in a pf, and manage it.
- Revenue versus capital taxation - know if the inv is taxed on a revenue account basis or a capital account basis, as they receive diff tax treatments.
- CGT discounting (tax trade timing, tax parcel selection) - know if it’s long gains or short gains upon selling
- Different tax groups - receipt of divs, FCs and management of CGs provide differing levels of benefit depending on the tax rates of the underlying investor , hence difficult to manage tax efficiency when diff tax groups in a pooled vehicle.
- Share buybacks - the after-tax outcome of an off-market buyback usually benefit investors with the lower marg tax rate the most (remember there is tax rebate on divs)
- Turnover - a strategy’s turnover rate (high or low) is not always an absolute indicator of after-tax efficiency. mgrs will just have to be cognisant of the after-tax impact of trading.
- Investment vehicles (pooled vehicle/inv trust, SMA/segregated mandate, CPM i.e. centralised portfolio management/centralised managed portfolio)
What is the axiom underlying institutional investors using tax adjusted performance benchmarks for Australian equity pf mgmt?
The underlying axiom is that since investors ultimately experience after-tax Rs, decisions should be made to max A/F Rs even if pre-tax Rs suffer. and ultimately, to remain competitive as managed funds since clients and industry have increasing focus on A/T performance measurement and reporting services.
What are the 3 important things to distinguish when basing performance fees on after-tax alpha as measured against an after-tax benchmark?
- behaviour that likely maximises a/t performance
- measurement of that behaviour - via a/t performance reporting ‘what gets measured gets managed’
- measurement of the efficacy of that behaviour - using A/T benchmarks
What is the main issue b/w mgr and investor when it comes to performance measurement? How can that be resolved usually?
The principal-agent disconnect i.e. mismatch between client’s and manager’s interests: investors experience a/t Rs whereas mgrs performance is measured against pre-tax benchmarks.
To align this mismatch, usually we increase mgr’s incentive to maximise a/t performance by using after-tax benchmarks to influence. mgr’s behaviours (although a/t alpha may come at the expense odf pre-tax alpha. )
and enforce a/t performance reporting - when a mgr must report after-tax performance, accountability towards after-tax Rs increases too. So the new legal requirement for super fund managers to calc performance A/T achieves this goal i.e. aligning the disconnect.
Name the 3 benchmarking methods for a/t performance measurement in order of increasing complexity?
- imputation index - generic by nature, grossed up for FCs, indices avail as off the shelf options
- tax-rule index - generic by nature, general assumptions made about CGs, indices avail as off the shelf options
- fully replicating pf benchmark - benchmark is effectively a pf set to the cost base of each pf measured at inception, mirrors capital flows/inspecie transfers, tax methodology; highly customised and expensive.
clients can usually give up some precision for the more generic after-tax indices to lower cost of benchmarking service.
What may be the disadvantage of a passive turnover strategy? Why is a high turnover pf inv strategy not necessarily better than a low turnover buy and hold strategy? What is an example where a high turnover strategy loses? An example where a low turnover rate is less attractive?
A low turnover strategy doesn’t equate to a superior after-tax investment outcome than that of a high turnover strategy, because passive turnover creates risk of forgoing alpha which may result in lower a/t Rs. An example where low turnover is less attractive - a pf with low turnover holds lots of unrealised CLs so tax benefits are not accessible until loss assets are actually sold
But high turnover is not necessarily better either, because numerous studies have shown that high turnover strategies tend to lose tax efficiency over time and requiral additional pre-tax Rs to match the after-tax performance of a low turnover strategy e.g. in a rising mkt, high turnover results in a large quantum of realised CGs which harm a/t efficiency of the inv
Name the 3 investment vehicles?
- pooled vehicle/investment trust
- segregated mandate aka SMA
- centralised portfolio management or centralised managed pf (CPM)
What is the main issue when managing a pooled vehicle/investment trust?
CGT over hang - since you are invested in a pooled fund, CGs can be incurred even when you are not invested, and similarly CLs can be incurred (which can be good) when you are not invested. So due diligence would dictate that new investors investigate the level of unrealised and realised CGs and CLs, likely capital distribution, the age of the fund (e.g .is the fund mature? declining as the age affects opportunities and risks ) before investing.
What are the main features of an SMA?
- client owns the underlying stocks ; the effect of using an SMA would be similar to investing in a pooled vehicle that is optimised from an after-tax perspective to specific tax rate/class of investors
- maximise ‘control, transparency and customisation’ to investor’s specific tax profile.
- switches from one manager to another : NOT a taxable event in an sma so it’s a tax advantage. whereas redemptions (inspecie or cash) in managed fund are taxable events and the tax implications will have to be managed.
Describe the general process of CPM (centralised portfolio management)?
It’s also known as ‘emulation’ or sophisticated after-tax investing, and usually only suitable for institutional investors. the investor/advisor employs a suite of active managers who send trades on their sleeve to the CPM manager who then aggregates and implements the trades in a centralised pf which has the ability to cross share trades, reduce tax and transaction costs and implement specific whole-of-portfolio tax management strategies, increasing the efficiency of the pf on an after-tax basis.
Explain how revenue account investment and capital account investment taxation work differently?
revenue account investments attract full tax at the investor’s marginal tax rate with no tax concessions; [mkt downturn] losses realised are tax deductible to investors
capital account investments are taxed under the CGT rules where tax concessions can apply; [mkt downturn] capital losses realised must be carried forward until gains are realised in future years.
general rule of thumb - FI/bonds are taxed on a revenue account basis; shares and units in managed funds are taxed on a captial account basis; generally through time, tax is a higher cost to rev acc and somewhat lower cost to capital pfs
inv mgrs should be aware of tax mismatches which can occur when gains and loses from diff rev and cap asset classes do not offset each other - the mismatches can result in investor having to pay tax on gross inv gains even when net inv performance is flat/negative.
What is the formula for calculating total capital gain in a financial year?
Total CG = LG (long gains) + SG (short gains) - CYL (current year losses) - BFL (brought forward losses)
