Post tax investment management a practitioner s perspective
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Post Tax Investment Management (a practitioner’s perspective). Presented by Geoffrey Brianton – Director Quantitative Advisers. March 2006. Shortfalls in Contemporary Practice. Tax. Franking Credits Earned. Net Return. Pre-Tax Return. Fund Managers are largely assessed on this.

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Post Tax Investment Management (a practitioner’s perspective)

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Post tax investment management a practitioner s perspective

Post Tax Investment Management(a practitioner’s perspective)

Presented by

Geoffrey Brianton – Director Quantitative Advisers

March 2006


Shortfalls in contemporary practice

Shortfalls in Contemporary Practice

Tax

Franking

Credits

Earned

Net

Return

Pre-Tax

Return

Fund Managers

are largely

assessed on this

Investors actually

care about this

Usually regarded as

an outcome of the process

For illustrative purposes only. Tax circumstances may differ. Diagram is not to scale

Tax Aware Investing


Reasons for discrepancy between practice and objective

Reasons for Discrepancy Between Practice and Objective

  • Prevalence of Pre-tax Surveys

  • Widespread use of Pre-tax benchmarks

  • Difficult to incorporate tax effects into trading decisions

  • Portfolio settings will differ despite a common outlook for stocks

  • Expensive / lack of consensus to calculate accurate post-tax benchmarks

Tax Aware Investing


Overview

Overview

  • Value of deferring Capital Gains Tax

  • Value of realising gains after 12 month

  • Value of Franking Credits

  • Roughly – what is it worth?

  • Does the marginal tax rate matter?

  • Can it be measured?

Tax Aware Investing


Value of deferral of capital gain i

Value of Deferral of Capital Gain (I)

  • Consider the following equity investment

  • $100,000 (Net)

  • $110,000 (Gross)

  • Portfolio has a beta of 1.1

  • Value of deferred CGT is the effect of the increased Beta

  • ….. but this assumes the investor does not respond to any accrual of CGT liabilities

Tax Aware Investing


Value of deferral of capital gain ii

Value of Deferral of Capital Gain (II)

  • Consider the following portfolio

    • $100,000 Equity (Net) $110,000 (Gross)

    • $120,000 Cash

  • Portfolio has a beta of 0.5

  • As CGT increases the investor could increase the cash holding

  • Value of unrealised CGT can be measured by the value of the implicit interest free loan

Tax Aware Investing


Simulated unrealised gains using all ords 1936 2005

Simulated Unrealised Gains (using All-Ords 1936-2005)

Tax Aware Investing


Long term average unrealised capital gain

Long Term Average Unrealised Capital Gain

Tax Aware Investing


Effect of turnover on capital gain i

Effect of Turnover on Capital Gain (I)

Tax Aware Investing


Effect of turnover on capital gain ii

Effect of Turnover on Capital Gain (II)

Tax Aware Investing


Franking credits

Franking Credits

  • Tax Credits to offset tax already paid by companies when the net proceeds are passed to investors in the form of dividends

Franking

Credits

Prima

Facie

Income

Tax

Cash

Dividend

Cash

Dividend

Prima

Facie

Income

Tax

Franking

Credits

Net

Return

For illustrative purposes only. Tax circumstances may differ. Diagram is not to scale

Tax Aware Investing


The value of franking credit i not priced into the asset

The Value of Franking Credit (I) – Not Priced Into the Asset

Tax Aware Investing


The value of franking credit ii fully priced into the asset

The Value of Franking Credit (II) – Fully Priced into the Asset

Tax Aware Investing


The price of franking credits iii off market buy backs

The price of franking credits (III) – Off Market Buy Backs

Tax Aware Investing


The value of franking credits iv hybrids

The Value of Franking Credits (IV) - Hybrids

  • At maturity: greater of $102.56 or 8.34 TOL shares

  • ‘Option-Adjusted’ Spread1.40%

  • Spread including franking credits4.38%

  • Franking credits are valued at 10% to 20% of face value

Tax Aware Investing


The value of franking credits v converting pref share

The Value of Franking Credits (V) – Converting Pref. Share

Tax Aware Investing


Summary of tax cost and benefits

Summary of Tax Cost and Benefits

Tax Aware Investing


Three steps towards a post tax benchmark

Three Steps towards a Post-Tax Benchmark

  • Deferral of Capital Gain

    • Value lost/gained interest free loan (using simple index fund as proxy)

      • Expressed as an annuity?

  • Realisation of gains under 12 months

    • Treat increased tax liability as loss of alpha

      • what about cash flows?

  • Tax Credits

    • Include tax credits as part of both the benchmark and the portfolio’s return

Tax Aware Investing


Wrap up

Wrap - Up

  • Contemporary Practice falls short in tax management

  • Benefits of tax awareness are significant

  • Costs for ignoring tax implication of trades can be high

  • The lower an investor's margin rate the more tax aware investing can be a source of Alpha

  • Higher marginal rates require higher Alpha to overcome the negative tax effects.

  • A perfect post-tax benchmark is (probably) too expensive but reasonable approximations can be made.

Tax Aware Investing


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