As Australia’s fund and superannuation sector digests Jeremy Cooper’s recommendations to improve the super industry’s governance, efficiency, structure and operation, it is evident that a competitive shake-up of the industry is imminent. Among the catalysts for this competitive overhaul is Cooper’s recommendation to introduce standardised reporting of investment returns by super funds - including post-tax performance reporting.
When it comes to providing members with transparent services and benefits, providing accurate post-tax performance reporting is crucial. For most superannuation entities, tax is the single biggest expense. An after-tax performance report shows clients the realistic return on their portfolio after paying taxes on income and capital gains. It also reveals to clients what margins are being added by their portfolio managers - creating a more transparent relationship between the client and the manager. Portfolio managers who introduce post-tax performance will find themselves with a distinct competitive advantage over those who choose to keep their clients in the dark.
While the enforcement of post-tax performance reporting comes with benefits, it also introduces a myriad of challenges that will test the mettle of portfolio managers’ tools and professional skills.
Gaining the upper hand
Introducing this form of reporting will undoubtedly benefit members and provide portfolio managers with a robust competitive advantage, but its introduction is not without challenges. Where measurement of performance on a pre-tax basis is well developed and standardised, the measurement of post-tax reporting is still in its early stages.
Individual tax circumstances, tax rates, investment objectives and characteristics all affect a manager’s investment policy for a taxable portfolio.
Some of the key factors that determine the tax efficiency of a portfolio include:
• Portfolio turnover - specifically, when capital gains are triggered
• Cash flows - and the tax burden of withdrawals
• Dividends vs. capital gains - which are taxed differently and therefore will produce different post-tax performance returns
Portfolio managers must also take into consideration how frequently and in what form, post-tax performance reporting can occur. Pre-tax returns can be calculated based on the valuation frequency throughout the year, however, calculating post-tax returns regularly can be difficult, as they may only be valued on a yearly basis, after the tax liability has been calculated.
The most common method for calculating post-tax performance is the ‘pre-liquidation’ method which accounts for taxes realised during the measurement period, but does not take into account unrealised taxes. To counter this, most fund managers need to maintain a simulated post-tax investment portfolio, for each investor tax class, on their books.
Another significant challenge for the industry lies in the development of appropriate benchmarks for post-tax performance. Benchmarks are widely published by exchanges for pre-tax reporting, however, until recently there have been no published benchmarks that address the affects of taxation on a product’s performance.
In a post-tax scenario, benchmarking performance is more complicated, as an assumed tax calculation must be used. The benchmark must reflect a certain turnover in the fund’s development which requires a significant amount of operational information. Fund managers may be able to make some simplified assumptions to reduce data requirements, however, the assumptions must still be documented and applied consistently to ensure appropriate performance estimates are made.
A new benchmark for success
Whether the government decides to adopt Cooper’s recommendations or not, post-tax performance reporting is already gaining traction in the sector as a competitive differentiator. In order to implement a truly tax-efficient portfolio decision, portfolio managers will need both the relevant tax information and the right tools. The unique nature of each investment portfolio makes it difficult for portfolio managers to rely on external providers to supply tax information and tools to calculate and benchmark post-tax performance. The different characteristics of each fund in trust of a portfolio manager will require specific data acquired through the trading process that the supplier will not have access to.
As much of the information required to implement post-tax reporting is available through the underlying investment information, portfolio managers could apply their own post-tax reporting methods through basic spreadsheets. However, this method presents significant issues with management, control and risk. The most accurate solution for portfolio managers seeking to implement post-tax performance reporting is to integrate the correct tools along with the portfolio’s existing decision making instruments. Integrating the correct tools allows portfolio managers to extract the relevant tax information, and analyse the tax implications of the proposed trades before they are made.
Portfolio managers will also have the advantage of being able to look through to underlying funds to calculate performance more frequently, provide reporting for different investment options and calculate performance at the four key tax rates and produce crucial after-tax benchmarks. Utilising an integrated system will also significantly reduce the risk for fund managers by allowing them to measure the fund’s performance at all stages of its development and provide the portfolio manager with a more accurate way of estimating the real performance of a fund after tax. Above all, portfolio managers must ensure that the information and tools adopted to calculate post-tax performance support growth, cost management and reduces risk for their clients.
Key considerations for determining a benchmark
Investable: Portfolio managers must ensure they have the capacity to invest in the options measured in the benchmark; to provide clients with a realistic estimate.
Simplified: The elements incorporated into post-tax performance calculations must allow the benchmark to be easily repeated throughout the year.
Appropriate: Benchmarks must suit managers’ investment styles and the differing turnover rates of their portfolios. It is critical that portfolio managers select indexes that reflect their investments.
Reflective of current investment opinions: Managers must be aware of current investment securities/factor exposures, as well as dividends and franking dividends versus capital gains, to determine how their performance will be affected.
Peter Hill is managing director of SimCorp Asia.