The value of the strategic advice an adviser provides is fundamentally judged by the return that a client gets to keep after fees and tax are paid.

Ensuring clients understand the value added through the advice process is the cornerstone of building successful relationships. A critical element of this mix is understanding how your client's investment is impacted by tax. Up until now, very few fund managers have provided detailed information about the after-tax performance of their funds to allow advisers to select funds on a tax effective basis. As a result some clients receive unexpected tax bills - never an ideal result. This is particularly relevant today as three years of strong markets have dissipated any tax losses of the past.

It is timely therefore that more attention is paid to the fund manager's approach to managing tax impacts within their portfolio.

Advisers who have this information available will be better able to construct investment portfolios that meet their client's needs and address potential tax issues.

Managed funds are structured as unit trusts and pass through taxable earnings to the end investor. Provided the trust distributes all its income to the unitholders, it pays no tax. This perhaps explains the lack of focus by managers on after-tax returns - ultimately the end investor's personal marginal tax rate and tax position determines the final outcome. However, the focus on pre-tax total returns (even after fees) does not give investors or financial advisers the real picture of how a fund's portfolio management will impact their tax situation.

To really understand how the fund manager's approach is affecting your tax position you need to have a detailed breakdown of the fund's return - not just how much is income and how much is capital growth - because within the income distributions there will be a mix of dividends and interest, short-term and long-term realised capital gains. It is the amount that falls within each of those categories that really determines how tax efficient or inefficient a portfolio is.

That information is not readily available to investors although this month the research company Morningstar has released the first set of after-tax performance data, so for the first time financial advisers will be able to compare some of Australia's leading share fund managers on an after-tax basis.

To better demonstrate the impact of tax, Vanguard has modelled three different portfolios - low, medium and high tax efficiency - and then compared it to the actual returns of the Vanguard® Index Australian Shares Fund.

To do this we took the average returns of the 15 largest Australian share funds and used Morningstar's data as the source for the split between the growth and income components.

For the financial year ended on 30 June 2006 the average return from the 15 largest Australian share funds was 22.3%.

From that return 14.9% was delivered as income - that is dividends and realised capital gains. Only 7.4% came in the form of capital growth in the unit price.

Compare that with the Vanguard Index Australian Shares Fund that had a return of 23.3% for the 12 months to 30 June with 14.8% the capital growth component and 8.5% income.

The data shows a stark difference - the average actively managed fund delivering almost twice as much in income rather than capital growth.

The real impact would depend on your personal marginal tax rate and whether or not you are investing through a structure like a self managed super fund. For investors on the highest marginal tax rate the impact is clearly the most pronounced.

Because most other fund managers do not report on an aftertax basis, as V nguard has been doing since October 2004, we looked at the tax impact on three hypothetical portfolios - same total return, same income and growth split. The variation is in the amount of short-term realised capital gains. Long-term capital gains are more efficient because the discounted tax rate effectively halves the amount of tax payable for individuals.

Therefore long-term capital gains are good, short-term realised gains which are treated as income and therefore taxed at your marginal tax rate are clearly less efficient.

Fund managers that actively turn over the portfolio during the year will typically have much higher levels of short-term capital gains in their returns and market data analysed by Vanguard suggests that some active managers turn over more than 100% of their portfolios in any 12 month period.

Consider this. If someone is on the highest marginal tax rate and invested $100,000 into the average large Australian share fund portfolio on 1 July 2005 a year later you may have earned a total return of 22.3%. But if you invested in the low efficiency portfolio - one with 100% short-term capital gains - then the tax payable on that fund investment alone would be $7,056. If on the other hand you invested in the high efficiency portfolio which has 100% long-term capital gains then the tax payable drops to $4,389.

The difference in the investment's after-tax value makes the point simply: the low tax efficiency portfolio is worth $115,194 while the portfolio with the more efficient use of long-term capital gains had an after-tax value of $117,861.

Because of the lack of reported data, it is impossible to make fund to fund comparisons at this stage, but the difference between the aftertax returns of two portfolios simply because one had high short-term capital gains and the other had all long-term capital gains and therefore enjoyed the discounted tax rate is significant.

In Vanguard's Index Australian Shares Fund we know the component breakdown. The index fund delivered 23.3% total return - slightly above the average of its largest actively managed competitors - with 14.8% capital growth and 8.5% income.

On a $100,000 investment the distribution breakdown was

• $3,551 dividends and interest
  
• zero realised short-term capital gains
  
• $4,598 long-term capital gains
  
• $351 tax deferred thanks to the specific tax treatment of distributions from property trusts The dividend level and tax deferred component were treated identically in the calculations of the average active share fund portfolios.
  

The same $100,000 invested by a highest marginal tax rate investor in the Vanguard Index Australian Shares Fund would be liable to tax of $2,837 for the 2005/06 tax year, leaving an aftertax value of $120,453 on 30 June, 2006.

Compare that with the worst case scenario - the low efficiency high turnover active portfolio where the tax due was more than double at $7,056 and as a result the after-tax value on just one year of performance was $115,194 - or $5,259 less
in the investor's back pocket.
Why does the index fund also beat the high efficiency active portfolio? The difference there is explained by the turnover.

Although there are no realised short-term gains in the high efficiency portfolio, as the fund buys and sells it realises the capital gains and they become taxable - albeit at the lower rate.

The index fund with its long-term buy and hold approach effectively defers realisation allowing the capital growth component to compound rather than paying tax earlier than perhaps you need to. A future tax bill may be owed when unrealised gains are ultimately realised.

The focus on after-tax returns is gathering impetus and it seems likely that the new super regime may well prove to be another catalyst for investors and advisers to demand the information from their fund managers that allows them to make an informed investment decision and select the right product for their tax and personal situation.


By Robin Bowerman, Head of Retail


Past performance is not necessarily indicative of future performance.