Taxes are one of the biggest costs to investors, and small changes in tax bills over an investment lifetime can make large differences to the final value of the investment portfolio. ETFs as an investment vehicle typically have a relatively high level of tax efficiency when compared to traditional actively managed funds – the amount of turnover within the portfolio is what makes an important difference.
Basic investment taxation – tax on disposal, concessional CGT rules
Gains and losses on the actual disposal of an investment are the basic trigger point for tax. Therefore, more buying and selling creates a greater potential for tax. If we look at Australian equities, Australian tax rules treat ETF and managed fund investment gains and losses under “capital gains tax” (CGT) rules.
CGT rules have an important benefit for disposals after an investment has been held for more than 12 months. In that case the disposer will only include 50% of the actual gain in their tax bill.
Higher turnover in traditional actively managed funds
The turnover of traditional actively managed Australian equity funds is around 75% pa (Source: Towers Watson “After Tax Investing in Australian Shares” January 2011). Because, in the main, ETFs buy shares (or other assets, depending on the type of ETF) and hold them “passively” (ie by just tracking an index), turnover in the ETF can be far lower: for example around 6% pa for broad market Australian equities ETFs (Source: BetaShares analysis).
The difference in turnover can lead to a significant difference in tax costs and therefore ultimately to returns. The traditional actively managed Australian equity fund tax bill subtracts approximately 0.6% pa, every year, from the returns of the fund (Source: Towers Watson). ETF tax costs may be less than 0.1% pa for comparable funds – far lower than the tax cost of the traditional actively managed fund.
Why is this important?
Most investors are, by now, familiar with the concept that reduced management fees can have a substantial impact on overall investment performance – and indeed low management fees are one of the primary contributors to the global success of ETFs. Perhaps less understood is the role that turnover can play on the cost of an investment and therefore to after tax investment performance. With statistics showing that the majority of “active” Australian equity fund managers typically underperform their benchmark (Source: S&P SPIVA Report, June 2012), the cost savings associated with low turnover provides yet another benefit of ETFs for investors, relative to traditional actively managed funds.