(pictured: Raewyn Williams)
The amount of tax saved from efficient after-tax management by super funds can vary through various market cycles, requiring different techniques to maximise returns. A new paper by Parametric illustrates the potential returns by treating the strategy as ‘tax alpha’.
The paper, “The New Recruit to Your Alpha Team”, was written by Sydney-based director of research and after-tax solutions, Raewyn Williams, and Seattle-based director of research, algorithm development, Hemambara Vadlamudi.
They found cross-sectional volatility in markets had the biggest impact on tax alpha. They also found that having shorter-term investment horizons, such as one year rather than 10 years, meant a greater variation in potential savings.
The paper also demonstrates the increasing sophistication of after-tax management, going far beyond simple tax-parcel matching which most super funds now employ in one form or another.
The paper says: “If after-tax returns are recognised and accepted as the appropriate baseline for a fund’s investment focus, then the pursuit of tax alpha becomes part of the game plan that superannuation funds can seriously pursue.
“In these volatile markets, superannuation funds need to exploit all the sources of market returns and investment alpha (outperformance) available to them.
“As a key element of this, it’s a simple intellectual exercise to recognise tax alpha as a lever funds can use to grow their members’ savings. Every dollar added closes the ‘retirement savings gap’, and members do not care how these dollars are added.”
Because funds are taxable, the authors contend, funds need to invest in an after-tax world and as such, tax should be seen as untapped source of potential investment alpha.
Williams said: “Funds need to challenge their anchoring bias around pre-tax returns. That is not rational thinking in an after-tax environment.”
The research shows tax is an important source of alpha, not the least because it can be added to existing pre-tax alpha sources so it is a “new, additive source” of returns.
“This differs from other alpha sources where a fund needs to make binary choices between ‘this alpha’ or ‘that alpha’ and hope these choices are right,” Williams said. “Because tax alpha is generally additive, funds can keep their existing alpha sources and add tax alpha as well.”
In addition, the authors show that tax alpha possesses all the qualities of other good alpha sources – it is persistent, expected and harvestable in a range of market and fund scenarios. They debunk the myth that funds need high turnover and/or portfolio overlap (redundancy) to generate tax alpha. Apart from a certain amount of turnover required to capture potential savings, there is little correlation between turnover and savings longer-term.
The paper argues that tax alpha is the result of particular skills and techniques, and cites eight examples where a tax-skilled manager can generate tax alpha in an investment portfolio:
- Tax lot selection – finding securities within a fund’s universe of holdings with the most favorable tax profile;
- Capital gains tax (CGT) discount targeting – determining, in the course of trading equities, whether delaying the trade would allow the tax rate on the trade to drop from 15 per cent to 10 per cent;
- Tax deferral – identifying where trades do not need to be done, or can be done in reduced quantities, or at a later time;
- Loss realisation – exploiting opportunities to crystalise an embedded tax loss by trading for investment reasons;
- Stock substitution – selling similar stocks with a better tax profile when the investment motivation for the trade is not stock-specific (such as to reduce a sector or factor exposure);
- Franking credit targeting – valuing franking credit yields on Australian equity portfolios;
- Buybacks and other corporate actions – electing corporate actions to support tax-efficient restructures and opportunities;
- Withholding tax management – minimising the ‘out of the market’ (or permanent) drag from withholding tax deducted from foreign equity dividends.
Williams and Vadlamudi say that what the research shows is, that it is possible to turn the challenge of managing tax ‘on its head’ and target favourable tax outcomes as an untapped source of alpha.
“Funds should see tax as a natural, harvestable part of the investment landscape rather than an issue they prefer not to think about”.