New Parametric research questions tax efficiencies of passive investing

New Parametric research has shown how tax-managed indexed results can potentially increase Australian superannuation investor returns, says Raewyn Williams, Director of Parametric’s Research & After-Tax Solutions.

Parametric, which manages over USD $136 billion in assets globally, offers investors a variety of portfolio solutions, including after-tax equity (performance measurement and indexed portfolio management), centralised portfolio management and systematic active strategies.

The new Parametric paper “Where Passive Falls Short: Presenting a True Tax-Managed Indexing Approach for Australian Investors” compares the results of a ‘tax efficient’ ASX 200 passive strategy with a true purpose-built tax-managed indexing strategy designed for superannuation investors and finds a meaningful difference between the two after-tax returns.

Ms Williams said; “In this paper, we show that there is a meaningful ‘tax cost’ to funds if they rely on a passive manager with no particular skills or knowledge about how to integrate tax into investment thinking. The purpose of this paper has been to answer the question of whether a pure passive investment approach really deserves its reputation as a ‘tax effective solution’ for superannuation investors.”

Using more than ten years of data our research shows there is a meaningful ‘tax cost’, being foregone savings from tax efficiencies, to funds relying on a tax-naive passive approach.

“Our research quantifies the additional savings from tax efficiencies in Australian and international equity portfolios that could be delivered to superannuation investors”, Ms Williams said.

“Our approach involves a specific after-tax focus and use of a ‘momentum’ factor tilt which lowers volatility and improves both pre-tax and after-tax returns,” she said.

“Momentum has attractive pre-tax risk and return attributes, and is naturally tax-efficient.”

Ms Williams said the stated benefits of a passive (low turnover) or ‘smart beta’ investment approach is often misleading and an oversimplification.

“Passive managers often don’t have tax-management capabilities and our paper identifies ten important differences between a passive equities solution and a true tax-managed indexing solution.

“The decision to invest either passively or actively into equities reflects a fundamental investment philosophy question for superannuation funds. With the more recent arrival of ‘smart beta’ and ‘systematic alpha’ approaches, increasingly, a fund’s investment choices sit along a continuum, rather than being merely a binary active versus passive decision.”

A new factor is influencing this choice for superannuation funds is the legal requirement for funds to demonstrate that, whatever investment philosophy they subscribe to, their approach includes tax considerations, and is focused on the members’ after-tax, rather than pre-tax, return outcomes.

The low turnover of passive investment styles has led to a perception that passive investing is inherently tax efficient.

In truth, passive managers also deserve the kind of after-tax scrutiny currently being applied to active managers and multi-manager structures and should not get a ‘free pass’.

Parametric’s research into ‘tax effective solutions’ for superannuation investors shows clear implementation efficiencies can be achieved.

Ms Williams added “Our tax-managed indexing approach is a three-dimensional solution which seems to fit squarely into funds’ needs. Its objectives and measured deliverables are after tax, it generates meaningfully better after-tax returns than a pure passive counterpart, and it retains its general character as a passive, rather than active, investment style.

“We encourage funds and their advisers to ‘scratch beneath the surface’ of the simplistic dialogue about the tax efficiencies of passive investing. There is increasing interest in making ‘dumb beta’ smart through the intelligent use of factor tilts.”

“We urge superannuation funds to make it truly smart by delivering what really matters to members – better after-tax returns.”