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Trade Tolls - Eureka Report Article

October 4, 2006
Trade Tolls
By Scott Francis

PORTFOLIO POINT: Investors are being short changed by fund managers with high portfolio turnovers. By minimising portfolio turnover you significantly reduce the capital gains tax payable on your investments.

Warren Buffett, the world's greatest investor was once asked what he viewed as the optimum holding period for a good stock. "Forever!" drawled the Sage of Omaha. It sounds like a cute repose, but like many pearls of wisdom from Buffett it makes a hell of a lot of sense once you understand what he really meant.

Earlier this week in Kohler on Monday we saw how fund managers were recklessly buying and selling shares in a constant attempt to improve their quarterly returns. Of course the real cost of this endless trading is to increase the taxes and brokerage charges faced by the investors who put money into these funds.

Retail investors invariably hear about pre-tax returns. The performance tables in your daily newspapers and the lavish promotional material for all the big funds from AMP to Zurich display pre-tax figures. For example over the last year Australian share funds on average returned 23.5% pre tax. But what difference does that make to you?

Pre tax returns are about as relevant to the private investors as the colour of a fund manager's socks: The figure that determines how much money you get in your bank account is the after-tax return made by your fund.

It should not come as a surprise that after tax figures are much more difficult to find. And you'll already know that the more often a managed fund 'trades' (or engages in buying and selling stocks) the greater the gap will be between the pre-tax and post-tax returns.

Today we look at just how much the often reckless trading of fund managers may be costing you - we also show in hard numbers just how much it costs for you to trade too much on your own account. If you want to invest like Warren Buffett you should be minimizing the number of times you trade - otherwise you have to ask the question, are you an investor or a gambler? What's more, do not forget that in addition to the additional CGT liabilities you pull in every time you trade, you also have to pay brokerage charges.

How too much trading hurts your bottom line

How much trading is too much? As a financial planner and avid reader of investment literature I would say that a turnover rate of 25% should be more than sufficient for a Eureka Report investor.

Recent research from the index fund management company Vanguard reveals that the aggregate turnover* of active managers is 76% of their portfolio a year. Separately, The ASX, in its 2005/06 annual report, reported that turnover for the year for the ASX, by value, was 87.7% of the total value of the sharemarket. I find these figures staggering: it means that active fund managers are buying or selling three quarters of all their investments each year. It also implies that every investment on the ASX is traded every 1 year and eight weeks.

Hang on a second! What ever happened to long term - or even medium term investing? Are we paying fund managers to invest our money in the best stocks or are we paying them to gamble our funds relentlessly? After all, we are surrounded by advisors recommending long term strategies - Clearly this advice is being ignored.

Though there will always be brokerage charges for either institutional or private investors - the core problem is tax. When you trade you realise a capital gains tax which works out at up to 46.5% of the profit from the trade every time you deal in the market. The cost of trading is that capital gains are realised.

Up until the time of the sale of an investment, the capital gain can be considered to be an interest free loan from the tax office. If you never sell the investment you never have to pay any capital gain tax - this is where Buffett's ' Buy Forever' rule comes into its own.

For large institutional investors these costs also include market impact costs, that is the negative effect that buying or selling large amounts of shares has on the share price.

How too much trading undercuts your managed funds returns

The managed fund industry keeps its after tax returns tightly guarded. The only people who really know just how wide the gap is between the reported pre-tax figures and the after tax figures are private investors in managed funds who find our the hard way when they try to reconcile their distribution statements with the much-vaunted pre -tax rates of return.

Luckily there is a window into this area through the lens of superannuation fund returns. Because tax is standardised in superannuation funds we get to see the after tax returns of superannuation funds. Now if we compare these after tax returns with the after tax returns of index funds - which trade significantly less - we get a clear picture of the true cost of trading. (Index funds are passive funds that try to exactly mirror an index such as the ASX 200, these funds try to minimize trading through custom made computer programs).

As you can see from the tables below - the superannuation funds (which would not be the worst offenders in this game) invariably destroy potential returns by trading too much.

5 Years to August 31,2006
Average super fund vs index fund return after tax

What's more, as new five year figures for the period to June 30 2006 from Industry specialist SuperRatings reveal too much trading by super funds clearly costs investors in terms of lost performance.

If you look across the table below - the performance of super funds against index funds is expressed in percentage terms (after tax) - super funds are trading too much.

5 Years to August 31,2006
Vanguard Index Return
SuperRatings Average Fund Return
After tax and fees
After tax and fees
Australian Shares
International Shares*
Listed Property

The after tax return of the average super fund was 13% a year for the past 5 years. The outcome for index funds that traded significantly less - using the Vanguard After Tax Index Return as a guide - is appreciably better at 13.7%. 0.7% a year does not sound like much however compounded over time it becomes important.

Moreover, once you move beyond the domestic equity investing the gap between pre-tax and post tax returns becomes more dramatic. With listed property trusts the non-trading outcome was substantially better - at 15.27% against 12.1%.

For international shares the after tax returns were a mere 0.9% - when investors were holding the same investments with lower portfolio turnover inside index funds the performance was THREE TIMES better at 2.79%.

How too much trading cuts returns on your direct share portfolio

Too much trading on your account takes a toll outside the managed funds environment too. For any investors with a direct share portfolio the hidden costs of constantly buying and selling can be seen from these two hypothetical portfolios. Both start with $200,000 and are invested for 10 years. In one portfolio the portfolio turnover is 88%, the average sharemarket turnover for last financial year. In the other portfolio the turnover is 25%. In both portfolios the investment returns are exactly the same. Income is assumed to be 4% a year, 90% franked, and growth is 8% a year each year. This provides an average return of 12% a year, close to the long term sharemarket average.

10 year after tax investment returns
25% portfolio turnover vs 88% portfolio turnover

The investor with the lower portfolio turnover has an extra $28,000 after ten years based on a super fund tax rate, an extra $40,000 based on a 31.5% tax rate and an extra $54,000 based on a 46.5% tax rate. Remember that's $54,000 made on $200,000 - in just ten years. In reality this gap would be even wider, as the higher turnover fund would have paid considerably more in brokerage.


The key message here is that when returns are weaker - and over the last year the weakest returns were in international shares, the positive effect of not-trading too much is at its most intense.

As we enter a period of anticipated lower returns on the ASX, with many observers predicting a return of single figures in the medium term - your ability to avoid trading or to avoid managers who insist on trading your money - will become much more important.

For long term investment success seek to minimize trading in your own portfolio and concentrate on fund managers that can produce above average returns without recourse to excess trading in the funds management sector... and remember pre-tax performance figures for fund managers make little difference to you, it's after tax returns that count.

* For the purpose of the article it has been assumed that international shares are 50% hedged, 50% unhedged. This is compared against a Vanguard portfolio that is 50% hedged and 50% unhedged.

Scott Francis is an independent financial planner based in Brisbane, he has an MBA from the University Of Queensland.