Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 231

The index investing story could be even better

The 2017 financial year was a good one to be a passive (index-tracking) investor in large cap Australian equities. The S&P/ASX200 returned 14.1%. Add to this the other attractions of passive investing – fees are typically lower than active management, taxes and transaction costs are lower, and investors know what they are getting. These attractions no doubt explain why around US$500 billion globally is leaving active equity strategies each year.

Large superannuation funds in Australia caught up in this global trend have an additional factor to consider. Australia, almost uniquely, taxes the investment returns of super funds. This makes passive investing an after-tax optimisation problem for Australian funds. While the headline 14.1% return is eye-catching, there is little insight as to what this looks like after tax or what tax management could have added to this good news story. ‘Dumbing down’ the after-tax optimisation problem to a simple ‘keep turnover low’ mantra does a disservice to the smart, sophisticated investment thinking most funds apply to other parts of their investment portfolio.

The forgotten effect of taxes

Most talk is on the extra tax a fund pays when moving from a passive to a factor-based or full active management style. But there are meaningful increases in tax just from moving from a theoretical ‘buy and hold’ strategy to a real-life index-tracking strategy which typically turns over 5-10% each year due to index reconstitutions, corporate actions and day to day fund cash flows.

It is a step in the right direction for a super fund to ask how much more tax could be payable by moving from a passive to factor-based or active investment approach. But given the massive flows in the other direction (towards passive), funds must also explore the whether there are ways to pay less tax in the way the passive investment strategy is implemented. Funds and asset consultants seem to stop short of asking this second question. It is not in the interests of the traditional passive managers (the beneficiaries of the flight to passive management) to raise it.

One way to differentiate a genuine tax-managed passive strategy from a simple ‘keep turnover low’ approach is in how loss stocks are treated in the portfolio. Consider the stock-level returns comprising the S&P/ASX200 over the 2017 financial year, as set out below:

Source: S&P, Parametric. Provided for illustration purposes only. It is not possible to invest directly in an index.

Utilising the losses to offset gains

A portfolio tracking this index could claim to be ‘tax efficient’ by naturally avoiding the realisation of gains on the 142 stocks which appreciated in value during the year. The accrued gains count for performance measurement purposes, but not for tax purposes – a good combination. But note the 70 loss stocks in the portfolio that depreciated in value over 2017. A traditional passive strategy has done nothing with these loss stocks, even though realised losses are valuable as assets which shelter from tax capital gains realised anywhere else in the fund’s portfolio (not just Australian equities).

In contrast, a genuine tax-managed passive strategy could naturally accelerate the realisation of these losses (within legal limits) to unlock their tax value and improve the after-tax returns of the portfolio further. In fact, the real opportunity set for an after-tax focused passive manager is not the 70 stocks in the S&P/ASX200 that returned a net loss but the 178 stocks that, through natural fluctuations in the market, were showing a loss at some point in time in 2017.

Using super fund capital gains tax rates, our published research indicates that this kind of intelligent after-tax thinking can add (pre-fees) around 25 basis points (0.25%) to an S&P/ASX200 portfolio and 30 basis points (0.30%) to an international equity portfolio each year. Franking credit strategies could add more. These extra returns are relative to traditional passive approaches which claim to be ‘tax efficient’.

An interesting sideline is that volatility, the enemy of most investors, actually becomes a useful tool in this exercise. This illustrates how the S&P/ASX200’s good news story for 2017 could have been even better if super funds were genuinely approaching passive investing as an after-tax challenge. Of course, if the index’s returns move closer to long-term averages (less than half of the 2017 return) in coming years, the extra return increments will be even handier.

Finally, genuine after-tax investing will report portfolio and benchmark performance both pre- and post-tax, which is the only legitimate way to show whether a ‘tax efficient’ strategy is living up to its claim.


Raewyn Williams is Managing Director of Research at Parametric Australia, a US-based investment advisor. This information is intended for wholesale use only. Parametric is not a licensed tax agent or advisor in Australia and this does not represent tax advice. Additional information is available at

Peter Vann
December 19, 2017

IMHO, funds that ignore the impact on after tax results from decisions they make are not adequately fulling their duties; the same applies regarding external manager mandates.

Whilst tax considerations in investment decisions require some grey cells, it is not hard and surprisingly still not done as a matter of course across the industry, even after much focus on this issues back in the late 1990s and early 2000, and thereafter.

One example: I know of an analysis done for a large super fund some time ago that simply looked at the impact of the back office parcel picking for CGT purposes following simple pragmatic rules (no impact on investment decisions and simply an accounting action); this analysis was done for the full transaction histories on a number of stocks and showed that there was between a few bps to 40 bps p.a. benefit in after tax returns, average benefit around 25bps p.a.. Was this (almost) free lunch ever implemented? Not to my knowledge. Who would throw away that return boost??

If index fund managers did this, then they would even surpass more active funds on an after tax basis. Well done Raewyn.

December 17, 2017

Raewyn's idea requires an element of active management which will be reflected in the management fees.

James Williamson
December 16, 2017

Do you know of any after tax return information on managed funds? I know vanguard put this on their website do you know of any others or an independent source.?


Leave a Comment:



What are the advantages and disadvantages of family trusts?

Why good active managers should outperform

The numbers tell the story for index investing


Most viewed in recent weeks

Is it better to rent or own a home under the age pension?

With 62% of Australians aged 65 and over relying at least partially on the age pension, are they better off owning their home or renting? There is an extra pension asset allowance for those not owning a home.

Too many retirees miss out on this valuable super fund benefit

With 700 Australians retiring every day, retirement income solutions are more important than ever. Why do millions of retirees eligible for a more tax-efficient pension account hold money in accumulation?

Is the fossil fuel narrative simply too convenient?

A fund manager argues it is immoral to deny poor countries access to relatively cheap energy from fossil fuels. Wealthy countries must recognise the transition is a multi-decade challenge and continue to invest.

Reece Birtles on selecting stocks for income in retirement

Equity investing comes with volatility that makes many retirees uncomfortable. A focus on income which is less volatile than share prices, and quality companies delivering robust earnings, offers more reassurance.

Comparing generations and the nine dimensions of our well-being

Using the nine dimensions of well-being used by the OECD, and dividing Australians into Baby Boomers, Generation Xers or Millennials, it is surprisingly easy to identify the winners and losers for most dimensions.

Anton in 2006 v 2022, it's deja vu (all over again)

What was bothering markets in 2006? Try the end of cheap money, bond yields rising, high energy prices and record high commodity prices feeding inflation. Who says these are 'unprecedented' times? It's 2006 v 2022.

Latest Updates


Superannuation: a 30+ year journey but now stop fiddling

Few people have been closer to superannuation policy over the years than Noel Whittaker, especially when he established his eponymous financial planning business. He takes us on a quick guided tour.

Survey: share your retirement experiences

All Baby Boomers are now over 55 and many are either in retirement or thinking about a transition from work. But what is retirement like? Is it the golden years or a drag? Do you have tips for making the most of it?


Time for value as ‘promise generators’ fail to deliver

A $28 billion global manager still sees far more potential in value than growth stocks, believes energy stocks are undervalued including an Australian company, and describes the need for resilience in investing.


Paul Keating's long-term plans for super and imputation

Paul Keating not only designed compulsory superannuation but in the 30 years since its introduction, he has maintained the rage. Here are highlights of three articles on SG's origins and two more recent interviews.

Fixed interest

On interest rates and credit, do you feel the need for speed?

Central bank support for credit and equity markets is reversing, which has led to wider spreads and higher rates. But what does that mean and is it time to jump at higher rates or do they have some way to go?

Investment strategies

Death notices for the 60/40 portfolio are premature

Pundits have once again declared the death of the 60% stock/40% bond portfolio amid sharp declines in both stock and bond prices. Based on history, balanced portfolios are apt to prove the naysayers wrong, again.

Exchange traded products

ETFs and the eight biggest worries in index investing

Both passive investing and ETFs have withstood criticism as their popularity has grown. They have been blamed for causing bubbles, distorting the market, and concentrating share ownership. Are any of these criticisms valid?



© 2022 Morningstar, Inc. All rights reserved.

The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.