Post-tax performance reporting by fund managers has been mandatory in the US since 2001. Here in Australia, it is optional, and most fund managers choose the easy option of reporting only pre-tax returns. Because what gets measured gets done, your fund manager’s focus is on pre-tax outcomes.
You might think the difference is hardly worth worrying about. Those that perform best on a pre-tax basis also perform best on a post-tax basis, right?
Sometimes, but oftentimes not.
Take this example of a current situation in the Value Fund. We have about 10% of the fund invested in RHG shares, purchased at an average price of $0.58 each. There are two choices for selling these shares. We can sell on market for about $1.00 each or we can tender into the company’s upcoming buyback and receive $0.88 in cash, comprising a fully franked dividend of $0.70, an unfranked dividend of $0.17 and a capital return on $0.01.
On a pre-tax basis, $1.00 is obviously better than $0.88. The extra 12 cents would add in excess of 1% to the pre-tax performance figures I report to my investors this year. That’s a meaningful number.
But, were I to sell those shares on market, almost all of my investors would be worse off. You can see in the table below the post-tax returns for investors on different tax rates under the two different scenarios (note that I am assuming the tax office allows us to utilise the capital loss, this is no certainty).
Investor's marginal tax rate
Post-tax return selling on market
Post-tax return selling into buyback
*super fund, 10% tax rate on discounted capital gains
**company, no discounted capital gains
Everyone except an investor on the top marginal rate is substantially better off if we choose to utilise the buyback. For a super fund with a tax rate of zero, the difference equates to about 2% of their Value Fund investment, double the annual fees.
So a perfectly rational fund manager, seeking to maximise their pre-tax returns, would do something that costs his or her investors up to 2% of their investment. Hardly an ideal outcome, is it?
The first step in rectifying this conflict of interest is to get your fund to report post-tax returns, at least once a year.
It’s not straight forward. As you can see in the table above, the results can be very different for investors on different tax rates. But it’s not that hard to produce a table just like the one above for the fund’s annual results, allowing you to assess the full range of scenarios.
And then hold them accountable. Tax matters, and your fund manager needs to know you care.
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.