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 When it pays to reinvest - Eureka Report Article 

March 10, 2008

When it pays to reinvest
By Scott Francis

 

 

PORTFOLIO POINT: In deciding whether to reinvest distributions, it pays to understand the difference between income and taxable capital gains.

Should you reinvest managed fund distributions? In a recent issue of Eureka Report I dealt with the issue of whether you should re-invest your dividends from ASX listed shares (See The money or the stocks?): But the issue of managed fund re-investments plans is much more vexed because there are some serious tax inefficiencies built into managed funds.

In automatically reinvesting your managed fund distributions - especially at the wrong time of the year - you can pay heavily for the apparent ease of the reinvestment facility.

To make a decision on reinvesting managed fund distributions, you need to get to grips with how managed funds pay back investors.

Broadly speaking there are three sources of positive return that you will receive from investments.
  • Income, such as the rent received from a property, the interest from a bank account, the dividends from shares and the distributions from listed property investments. This is taxable, however franking credits from Australian share income and tax-deferred/tax-exempt income from listed property may offset some of the tax to be paid.
  • 'Realised' capital gain. This means is that you have sold an asset that has increased in value, and how have to pay tax on the sale.
  • 'Unrealised' capital gain. This means that you have received a return because an asset has increased in price and have yet to sell the asset. For most investors, this is the best sort of return you can get because you don't have to pay tax on it.

It is the third sort of gain that is particularly important to investors. Because you have had a positive investment return as an asset appreciates in value, but don't have to pay any tax on that return until you sell it, you can think of the unpaid tax liability as an interest-free loan from the tax office. The longer you defer selling the investment, the longer you defer having to pay on the capital gain!

This is the problem with many managed funds because they are trading often to try and beat the market and because they have to trade to match the money flowing into and out of their fund with redemptions and contributions; they don't accumulate much in the way of what we might describe as the "tax-postponed capital growth", the tax-effective investment return that you want to receive.

A practical example

I recently had reason to look at the performance of the Colonial First State Imputation Fund for a client. It provided a good demonstration of the tax-ineffectiveness of some managed funds.

In the two graphs below, I have compared the returns from the wholesale versions of both the Colonial First State Imputation Fund and the Vanguard Australian Shares Index Funds for the three and five years to the end of January 2008. The index fund is a good proxy for the average market return and, because it is an actual fund, provides a real example of how this return has looked.

The three-year returns show that the total return from the index fund (in blue) is about 2% a year higher than the Colonial fund. You can also see that the average annual distribution from the index fund is 5.31% compared to the taxable annual distribution of 18.76% from the Colonial fund. That means that over the three years the index fund has returned tax-postponed capital growth of 10.27% a year, while the Colonial units have fallen in value.

The story over five years is similar, with the index fund providing tax postponed capital gains of 10.27% a year, with the Colonial Fund proving only 1.93%.





In the most recent look at managed fund performance (See Big-name funds disappoint), we found that the average distribution for the managed funds in the survey was 15.46%.

Consistent with the fact that most of the distributions are actually realised capital gains and not income, the Colonial First State Imputation fund had a franking level of just over 12.5% in both the 2006 and 2007 financial years. Interestingly, in its December 31, 2007, Option Profile and Commentary, Colonial states its investment objective is to "provide long-term capital growth with some tax effective income". Results suggest Colonial is are not meeting this objective.

So should you reinvest managed fund distributions?

There will always be investors who simply re-invest every time, whether it is in dividend reinvestment plans or managed funds redistribution plans. Many investors don't want the hassle of untangling their ongoing investments; many more do not want to engage in the extra work involved in investing the cash in another asset.

But don't assume the issue is the same for shares and managed funds: When you receive dividends from shareholdings, you know that the money being received is investment income. When you receive a distribution from a managed fund, there is the chance that a high proportion of the distribution is not income, but realised capital gains.

Because of this, it is often makes more sense to reinvest managed funds distributions. At the very least, greater consideration must be given to reinvesting at least a portion of the distribution.

Consider a retiree with a Colonial Imputation Fund investment. Over the past five years they have been receiving distributions of 14.88% a year. If they were happily spending these distributions, thinking that they are the income produced from their investment portfolio, they would have an unrealistic expectation of the underlying investment income, which would actually be a lot lower, more in the range of 5-6% a year. Most of what they are spending is realised capital gains from trading. Effectively they are spending their capital, and may not even be realising it.

Timing a managed fund investment

Most managed funds make their major distribution for the year at the end of the financial year. You should be careful about investing just prior to this time, as you will still receive the full distribution for the year.

For example, the unit price for the First Choice Colonial First State Imputation Fund on June 29, 2007, was $1.2017. On June 30 a distribution was paid of about 13.5 per unit. The unit price for the fund then fell by the amount of the distribution of 13.5, to $1.0665.

An investor who invested just prior to the end of the financial year would open themselves to a double whammy they have seen their investment fall in value by more than 10%, while having a taxable distribution of the same amount.

Conclusion

The only thing that matters to us as investors is after-tax returns. Managed funds tend to muddy the waters of what is income with large distributions often made up primarily of realised capital gains from high levels of trading. The regular high proportion of realised capital gains in managed funds distributions it can more often make sense to reinvest managed fund distributions.

It pays to keep your eyes on the "after-tax prize", and to understand what is income and what is taxable capital gains when it comes to a managed fund distribution.

Scott Francis' articles in the Eureka Report 

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