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 parametricportfolio.com.au.

3 Comments
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.

Nick
December 16, 2017

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

James Williamson
December 15, 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:

RELATED ARTICLES

Are markets broken?

The when and why of four million Australian retirees

Who needs the Caymans? 10 ways to avoid paying tax

banner

Most viewed in recent weeks

Simple maths says the AI investment boom ends badly

This AI cycle feels less like a revolution and more like a rerun. Just like fibre in 2000, shale in 2014, and cannabis in 2019, the technology or product is real but the capital cycle will be brutal. Investors beware.

Why we should follow Canada and cut migration

An explosion in low-skilled migration to Australia has depressed wages, killed productivity, and cut rental vacancy rates to near decades-lows. It’s time both sides of politics addressed the issue.

Are LICs licked?

LICs are continuing to struggle with large discounts and frustrated investors are wondering whether it’s worth holding onto them. This explains why the next 6-12 months will be make or break for many LICs.

Australian house price speculators: What were you thinking?

Australian housing’s 50-year boom was driven by falling rates and rising borrowing power — not rent or yield. With those drivers exhausted, future returns must reconcile with economic fundamentals. Are we ready?

Retirement income expectations hit new highs

Younger Australians think they’ll need $100k a year in retirement - nearly double what current retirees spend. Expectations are rising fast, but are they realistic or just another case of lifestyle inflation?

Welcome to Firstlinks Edition 627 with weekend update

This week, I got the news that my mother has dementia. It came shortly after my father received the same diagnosis. This is a meditation on getting old and my regrets in not getting my parents’ affairs in order sooner.

  • 4 September 2025

Latest Updates

Shares

Why the ASX may be more expensive than the US market

On every valuation metric, the US appears significantly more expensive than Australia. However, American companies are also much more profitable than ours, which means the ASX may be more overvalued than most think.

Economy

No one holds the government to account on spending

Government spending is out of control and there's little sign that Labor will curb it. We need enforceable rules on spending and an empowered budget office to ensure governments act responsibly with taxpayers money.

Retirement

Why a traditional retirement may be pushed back 25 years

The idea of stopping work during your sixties is a man-made concept from another age. In a world where many jobs are knowledge based and can be done from anywhere, it may no longer make much sense at all.

Shares

The quiet winners of AI competition

The tech giants are in a money-throwing contest to secure AI supremacy and may fall short of high investor expectations. The companies supplying this arms race could offer a more attractive way to play AI adoption.

Preparing for aged care

Whether for yourself or a family member, it’s never too early to start thinking about aged care. This looks at the best ways to plan ahead, as well as the changes coming to aged care from November 1 this year.

Infrastructure

Renewable energy investment: gloom or boom?

ESG investing has fallen out of favour with many investors, and Trump's anti-green policies haven't helped. Yet, renewables investment is still surging, which could prove a boon for infrastructure companies.

Investing

The enduring wisdom of John Bogle in five quotes

From buying the whole market to controlling emotions, John Bogle’s legendary advice reminds investors that patience, discipline, and low costs are the keys to investment success in any market environment.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
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. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. 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.