Raewyn Williams - Investment Innovation Institute

Raewyn Williams, Managing Director of Research, Parametric

Control What You Can Control

Implementation efficiency in large investment portfolios is a topic that lacks the glamour of, say, heavy-lifting asset allocation, edgy stock-picking or heroic predictions about market direction and themes.

But for large Australian superannuation funds, paying more attention to controllable portfolio leakages caused by investment taxes and transaction costs can be a new, untapped source of value as they navigate increasingly difficult investment conditions.

In fact, starting with a “control what you can control” mindset may be the most responsible thing a fund can do in the face of fewer opportunities and diminishing convictions about investment markets.

Australian superannuation funds pay tax on the investment earnings of their pre-retirement assets, which is very unusual by tax-exempt world pension fund standards.

In new research, we note the growing impetus for Australian funds to address what has been called a ‘breathtaking misalignment’ between their pre-tax investment focus and the after-tax returns which actually create retirement wealth for superannuation fund members. This is actually mission heartland for funds.

A 2010 Australian Government-commissioned review suggested superannuation funds were potentially wasting as much as 200 basis points a year on equity portfolios by ignoring the impact of investment taxes (although we believe this is overstated).

A different review released in January this year attempted to assess how well funds are addressing this misalignment and clawing back the lost portfolio value – but gave up in rather spectacular fashion citing a lack of data.

Our research explains why estimates of tax leakage have been over- and under-estimated at different times. A good conservative guide – post all fees and costs – is around 59 basis points annually on a portfolio of listed equities.

Modeled over the working life of a superannuation fund member and into retirement, the value of better controlling investment tax leakage is almost twice the value of stripping fees out of funds – better tax efficiency equating to about $96,000 extra for a superannuation fund member in retirement compared to lower-fee investing.

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Based on our modelling of a large cap Australian equity portfolio, every $100,000 of equity trades might cost as little as $420 or as much as $2,380

That is important food for thought at a time when the industry, under the relentless scrutiny of the Australian regulator, political parties and other high-profile commentators, is focusing on fee levels but remains uninformed and, for many funds, unmotivated to address controllable tax leakages.

Our new research also notes that Australian superannuation funds are very overweight equities by world standards (for reasons that are sensible), but struggle to answer the fundamental question: How much does it cost to trade equities?

Like taxes, transaction costs are a kind of controllable cost, and for a variety of reasons funds may not realise how much they are paying. More to the point, many funds are unaware how much less they could pay and what they are getting in return for paying above ‘best rates available’ on any trading day. Based on our modelling of a large cap Australian equity portfolio, every $100,000 of equity trades might cost as little as $420 or as much as $2,380.

The differences in trading cost outcomes may be perfectly sensible, but funds have no way of knowing because the costs are embedded in net returns; typically not reported and not subject to market discipline or fund scrutiny.

Europe’s ‘MiFID’ regulatory regime introduced a set of rules in January 2017 to unbundle and disclose trading cost arrangements across its markets. According to the UK’s Financial Conduct Authority, this has (so far) forced down the research component of trading costs by 20-30 per cent across Europe.

It is a telling example of what a focus on these controllable costs might yield for superannuation funds in Australia, where average trading costs are much higher than in Europe’s developed markets (in fact, amongst the highest in the developed world).

The key message in our new research is that superannuation funds have a way to ease the pressure of having to navigate the ‘random walk’ of equity markets, get their heroic bets right to produce alpha and negotiate ever-skinnier fee budgets.

A fund’s pathway can look like this: first, explicitly articulate a ‘control what you can control’ philosophy; second, bring visibility to hidden leakages through tools like after-tax performance reporting and transaction cost analyses; and third, engage with investment partners who care equally about portfolio transparency and can help funds harvest a payoff from managing these costs.

Raewyn Williams is a Managing Director at Parametric in Australia. Her full research paper can be found here.

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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.