Applying professional after-tax management in the transitioning of portfolios by super funds can save at least 30bps in the portfolio’s change-over costs, according to new research by Parametric, the specialist implementation manager. Transition managers don’t always look closely at after-tax impacts.
The research report, ‘The Sting in the Transition Tail’ says that both specialist transition managers and their super fund clients often have a blind spot around the potential cost of extra tax in a transition.
The report presents a hypothetical equity transition scenario to investigate the blind spot, discovering a typically ignored ‘tax sting in the transition tail’ more than six times larger than the always-addressed impact of transaction costs. According to authors Raewyn Williams, Parametric managing director, research, and Joshua McKenzie, analyst, such a result “hardly seems logical”.
They argue that the typical transition manager looks to optimize between two competing portfolio objectives: minimizing the time taken to move from the legacy to the target portfolio and minimising both explicit and implicit transaction costs of moving from the legacy to the target portfolio.
A super fund can support transition planning by stating which of the two goals is more important. A good transition manager can assist by modelling alternative outcomes along an efficiency frontier to help the fund understand the trade-offs.
“There’s no tax awareness in this common framing of the transition task. Yet Australian superannuation funds pay a headline 15 per cent tax rate on investment income and realised gains— with certain discounts and credits possible—so transitions can easily trigger tax. As a general rule, the larger the changes, the larger the possible tax bill,” the report says.
Patrick Liddy, principal of efficiencies and marketing consultancy MSI Group, and a former head of transition management at UBS in Australia, says it is true that transition managers do not always pay sufficient attention to the after-tax impact of their transitions. They tend to be focussed solely on the headline costs.
“When you are dealing in the front-office of managers and their
service providers, you generally find that the headline costs and
potential returns tend to dominate the thoughts and minds of the
portfolio managers. But, as the research paper shows, tax can be the most significant cost in a transition – even more significant than opportunity costs, which are also often under-estimated.”
As well as using a hypothetical example to illustrate the principles of tax-aware transition management, Parametric’s report also examined an actual transition managed during March for a super fund client to show that using “traditional” processes, there could be a tax on capital gains of up to 3 per cent ($110 million in this instance), but this should be as low as $25 million using a tax efficient approach, such as centralised portfolio management (CPM, which is a service provided by Parametric).
“The more a super fund contemplates portfolio changes, the more it should be motivated to find a specialist platform like CPM to implement these changes to ensure that all the costs of their change programme are managed well, including tax. A fund’s goal should be this: 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.”