By Robin Bowerman
August 2006

Investors in Australian share funds had every reason to be happy as the accountants ruled off the 2005-06 financial year at the end of June.

After all Australian shares delivered 20% plus growth for the past three years even after a flat last quarter of the financial year. According to the research group Morningstar performance numbers for the 12 months to June 30 the average return from the 15 largest wholesale share funds was 25.3%; in the retail category the average return was 22.3%.

But behind those numbers is another story - a story that is becoming clearer right about now as fund managers mail out their annual tax statements.

While most fund managers do not report after tax returns they do split out the income and growth components of the total return which is a useful proxy to see how tax effective a fund's return really is. Morningstar will soon start reporting after tax returns in what will be a first for an Australian researcher.

Why is this important? Well the after tax return is what an investor gets to keep - it is really the most important return number of them all. But the order of importance depends on what type of taxpayer you are. If you are on the highest marginal tax rate then it matters a great deal indeed. If you are a retiree with your investments in an allocated pension the tax factor is much less an issue.

Managed funds operate as trusts and are transparent for tax purposes - this means earnings are passed through to the investor to deal with as part of their personal tax return. On the condition that the trust distributes all its earnings it does not pay tax.

Where funds can be more or less tax effective depends on how the return is derived. Every share fund will usually have a mix of long and short-term capital gains and income from dividends.

Take the position of a high marginal taxpayer. A 20% return would be a lot more effective if it was all delivered as long-term capital gains rather than income. If it is delivered as income then the full marginal tax rate of 47% applies. If it was long-term capital gains then the CGT discount applies and the tax rate is halved.

It is the breakdown of the components of the return that is critical to determining how tax effective or otherwise a fund is. How much is growth versus income and then how much of the growth is long-term or short-term capital gains. This is where the fund manager's approach to portfolio management has a major impact. High portfolio turnover equals income which may equal higher levels of tax for people on the higher marginal tax rates.

This is also an issue for financial advisers because they can recommend a share fund in good faith only to find it gives their client an unwanted and unexpected tax bill.

When you look at the top 15 wholesale share funds by size you see that a massive 16.3% of the total return of 23.7% was delivered as income and only 5.89% as capital growth. That is almost the reverse of what you would expect if you looked at the dividend distributions across the broad market index.

By way of comparison Vanguard's Australian Index Share Fund had a total return of 23.7% of which 6.9% was income and 16.8% was growth. Vanguard has led the way by reporting after tax returns and this year's numbers powerfully demonstrate the value of being able to see the after-tax returns of funds so investors and advisers make informed choices.




A contributing factor may be that we have just had three strong years of returns so the capital gains loss cupboard is bare so a lot of fund managers have nothing to offset their tax position with.

Clearly a lot of major funds are being managed without a weather eye on tax. Some managers will suggest their overriding task is to buy and sell stocks to maximise the portfolio's total return. Clearly that is a fundamental goal but to ignore the reality of the tax position seems to be short-changing the investors on whose behalf the fund managers are investing.

* Vanguard Investments Australia pays a subscription fee to use Morningstar data.