Taxes, investment costs and investment returns

High before tax returns may not be best …

If you accept the often repeated warning that past investment returns do not provide a guide to future performance, you would be smart enough to not select a fund manager based simply on their recent results.

But what if you knew for certain (which you couldn’t) that a particular investment manager would return 1% p.a. above their relevant market indicator, before investment costs and taxes, for the next 10 years. Would you select that manager in preference to one that guaranteed you the market return? As we demonstrate, not necessarily.

Your objective as an investor should be to maximise your investment returns after-tax, costs and inflation for the amount of risk you accept i.e. your net risk adjusted return. In this article, we will focus on the importance of taxes and investment costs (e.g. fund manager fees, transaction costs). We have discussed the risk issue extensively in our “Foundations of Financial Economics” articles and, excluding inflation indexed bonds, there is little an individual investor can do, directly, to take account of inflation.

Taxes and investment costs can severely reduce the amount of money that ends up in investors’ pockets. Investment managers that are inefficient in the management of these components of your net risk adjusted return need to generate significant, reliable pre-tax and cost outperformance to compensate.

How tax structure, investment costs and the composition of investment returns interact

To examine how taxes and investment costs affect net investment returns, we assume an investment earns a before-tax, inflation and costs return or gross return of 9.2% p.a., for ten years. This happens to equal the return of the relevant market indicator for that type of investment i.e. it is “the market” return.

With inflation assumed at 4% p.a., an after inflation gross return of 5% p.a. is implied. Over ten years, $1,000 would grow to $1,629 in today’s dollars. We will call this “gross real wealth”. As we shall demonstrate, taxes and investment costs eat into gross real wealth to varying degrees.

As discussed in “Ownership of family wealth”, the amount of tax payable will be driven by who owns the investment. We look at four situations:

• A top marginal tax rate individual, paying 46.5% tax on income and 23.25% on capital gains;

• A company, paying 30% tax on both income and capital;

• A super fund, in the accumulation phase, paying 15% tax on income and 10% on capital gains; and

• A super fund, in the pension phase, paying 0% tax on both income and capital.

Given the differences between taxes paid on income and capital by ownership structure, the amount of tax payable will also depend on how the total pre-tax return on the investment is divided between ongoing income distributions and capital growth. We consider two cases: 35% and 65% of total return distributed annually as income, with the rest as capital growth.

And, finally, we look at two investment management costs’ scenarios: a “low cost” investment manager, at 0.50% p.a., and a “high cost” investment manager, at 1.50% p.a.

The table below shows the growth in the $1,000 (after allowance for investment costs, tax and inflation) over ten years for each of the identified scenarios:

Growth of $1,000: By structure, income distribution percentage and fees

To highlight the impact of tax structure, the composition of returns and investment costs on your wealth, the following table shows end wealth for each of the above scenarios as a percentage of gross real wealth, of $1,629:

Percentage of Gross Real Wealth: By structure, income distribution percentage and fees

Clearly, investment costs and taxes hurt. A high income distributing, high cost investment approach must obtain a significantly higher pre-tax gross return than a low income distributing, low cost approach to provide the same net return. And the amount of outperformance required will depend on ownership structure.

The table below shows the implied amount of outperformance for a high income distribution, high cost investment approach compared with low income distribution, low cost approach, for each structure:

Taxes and costs matter, greatly

The moral of the story is that to justify investor consideration investment managers charging high fees and making large ongoing taxable income distributions (usually because they actively trade their investment portfolios) must be expected to significantly outperform the market, before taxes and fees. And the less tax effective the investment ownership structure, the greater that outperformance needs to be.

The decision a potential investor must make is how likely is that degree of outperformance, over sustained periods of time. And allowance must also be made for the reality that market outperformance also requires taking greater than market risk.

Unfortunately, while attempts to choose superior performing investment managers could result in above market gross returns, they could just as easily lead to less than market returns, and with higher costs and more tax!

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