By Greg Bright
Believe it or not, there are a few free lunches in investment management – strategies which can deliver savings that are the equivalent of no-risk alpha. The biggest of these, the longest free lunch if you will, is after-tax management. Last week investors and managers spoke out on the issue.
At roundtables in Melbourne and Sydney, organised by PwC Investment Consulting, investors detailed their experiences with and opinions on after-tax management of investments and other ways to improve efficiency in investments.
PwC published a paper this year which Stephen Jackman, a director of investment consulting at the firm, says is one of the most important papers it has produced in the past few years. The paper says that, unlike other aspects of investment management, tax efficiency gains are real and consistent. The gains from picking stocks or asset classes, on the other hand, may be illusory and volatile.
“When we started our research,” he said, “we were really surprised to see how much money is involved. We say at least 50bps but that’s probably the low end of the range. So, the big question is: why isn’t everyone doing it?”
Chris Briant, the chief executive of Parametric for Australia and New Zealand, said that APRA data shows the tax paid by members in their super fund was usually greater than the total fees they paid to fund managers. “It is the biggest single cost for a super fund. As the SIS Act has recognised, everyone needs to address it,” he said.
One fund which has introduced better after-tax management is Catholic Super. Garrie Lette, Catholic Super’s CIO, said that when it introduced after-tax management four years ago there was some initial “push back” from managers, “but not a lot… we are the client after all”.
In the process Catholic Super noticed some “wide variations” in the after-tax performance of its Australian equities managers, Lette said. For instance, its smart-beta manager was, by far, the most tax efficient.
He said: “Their initial reaction was that this would make it harder for them to achieve their performance fee, which it did. So there was a vigorous discussion around that. But, at the end of the day, we hold the whip hand. And it’s in members’ best interests.”
PwC estimates that about 50 per cent of big super funds are addressing the after-tax management issue in various ways. “Why aren’t more people focusing on this?” Jackman said. “There is a range of different things they can be doing. In the whole spectrum there are only a few doing the full CPM solution [tax-managed centralised portfolio management (CPM), as provided by Parametric]. Most people say they are doing something but, usually, they are doing very little.”
Raewyn Williams, Parametric’s managing director, research, and, like Briant, a former Russell Investments consultant, said that funds could start their after-tax management in a “cheap and easy way” with tax parcel optimisation (TPO). This is a backoffice function which does not involve direct engagement with the managers, but rather sorting through the trades and matching them efficiently after the managers have dealt. CPM, on the other hand, is “disruptive”, Williams said.
An examination by Parametric of some of the trades of 16 funds showed that TPO delivered savings of about 5-10bps per year, while the benefit from CPM would have been between 50-90bps.
Williams also produced a paper this year, entitled “The New Recruit to Your Alpha Team”, which showed: “Once after-tax returns are accepted as the more appropriate baseline for a fund’s investment focus, it is a simple intellectual exercise to recognise tax alpha as a lever funds can use to grow their members’ savings.”
At the Melbourne roundtable last week, David St John, an investment committee member of Legalsuper and former CIO of UniSuper, said the issue should be picked up by boards in their strategic plans. However, “at the end of the day it’s management’s responsibility to gather all the pieces together and put the case to the board.”
He said that there were a number of key players in the decision to move toward a more tax efficient process, including the managers, custodians, administrators and asset consultants.
With administration, the matter has the potential to provide additional benefits outside the traditional investment management processes for a fund (see separate report). For instance, the cashflow of big funds is such that it means they can wield more power with their banks and add another incremental basis-points benefit to members.
Lette said that Catholic Super was still not certain whether its move to after-tax management had “worked”. It was a “leap into the dark”, he said. “What we do know is that we’re saving on performance fees.”
Jackman said: “There is a degree of certainty with all this that you don’t have elsewhere… People could be doing a lot more and should be doing a lot more.”
Patrick Liddy, a former custodian and now a consultant with MSI Group, said that while after-tax management was starting to permeate throughout the industry, with bellwether funds such as AustralianSuper embracing the concept, the asset owners did not want to “alienate” their managers. “You don’t want to chase away good managers,” he said.
The issue for managers is that if a fund aims to extract maximum benefits from an after-tax management process, by using a CPM system, the fund managers will no longer be in control of their trading activities. In order to maximise the gains for the client’s members, the CPM will choose which parcel to trade and when it should be traded, upon the guidance of the manager.
Liddy, who specialises in implementation efficiencies for funds and managers, said: “There are a lot of savings to be had in FX and cash too. FX is interesting. You can front-run in FX trading and no-one goes to gaol. But if you did it in equities you are in big trouble… When AussieSuper retailised its cash [on its member-directed investment option platform]it got an extra 85bps for members.”
This refers to the anomaly whereby, following regulatory changes such as Basel III, small retail customers get paid a higher interest rate on their cash than big wholesale customers.
Lounarda David, another former custodian and operational consultant who is the head of investment operations at Sunsuper, said she would like to think that the larger funds had the topic near the top of their agendas. However, it is difficult to proceed with implementing more tax-effective strategies without the internal knowledge and experience of the end to end implementation process, good technology, timely data and scale to benefit from such models as they can be vey complex.
“Like it or not, the return will capture the tax leakage and inefficiencies in the process… But, the solution is not ‘one size fits all’. It’s a complex issue and there are trade-offs. To determine the optimal strategy, you need a good understanding of the underlying investment vehicles, managers operating models and execution arrangements. So, you can properly adjust the process for each investment. Tax inefficiency generated from the private market investments are a lot more expensive than listed assets, if the structure of the investment vehicle is not carefully considered. Understanding all of these elements requires more than just a knowledge of the tax system… With us [Sunsuper] we don’t look at tax in isolation.”
The industry trend was for more and more focus on costs and more fee pressure, and this would only get worse, she said. This meant that the net results for members would continue to be scrutinized closely. Superfunds are trying to improve their investment efficiency and reduce leakage, so they can deliver a better return for their members.
“A lot of costs that funds have traditionally recovered, such as manager and administrator fees, have gone down, but other costs, such as the costs of [regulatory]compliance have gone up. I think, though, the overall value that the member is getting has improved.”
Notwithstanding the obvious benefits, not all super funds engage in after-tax management and some of the other ways to save money that they could. Chris Briant believes that the fact that US pension funds do not pay tax meant that Australia did not have a ready after-tax system it could import, so we have had to develop the system and process ourselves.
Don Hamson, founder and CIO of boutique equity manager Plato Investment Management, said that when Woodside tried to pay $1 billion of franking credits to Shell in 2014, Plato was the only fund manager to come out to fight for Australian investors on the matter. The firm won the day, by the way, getting the shareholders’ meeting to vote the proposal down, which doesn’t happen very often in Australian corporate life.
Hamson, who was also involved on the advisory committee for the recent launch of the S&P after-tax indices, said that he first became interested in the after-tax issue in the late 1990s when he took over the management of a tax-effective share fund “because no-one else wanted to do it”. Analysts want to pick stocks, he said. Up until recently, fund managers tended to look only at what was happening in their “silo”. Because Plato handles a lot of pension fund money, it has always looked at the bigger picture.