In a recent article1 we made the point that while investors are encouraged to remain invested through the cycle, there are several warning signals that should trigger the re-evaluation of their investment in consultation with their financial advisor. The article generated much interest, with advisors identifying the following additional triggers:
Significant cashflows in either direction over a short period of time may impact a portfolio manager’s ability to implement his investment philosophy. Monitoring cashflows is therefore important. In this regard, it is also important to understand how concentrated the ‘ownership’ of the fund is, as a fund with a few large investors could be materially impacted should one or more decide to exit.
Assets under management
Certain investment philosophies’ ability to deliver outperformance reduces as assets under management grow and portfolios become unwieldy. It is crucial that the asset manager has the discipline to close to new investments and not succumb to greed.
With managers now able to invest up to 30% offshore and a further 10% to Africa ex-South Africa (in respect of Regulation 28-compliant funds and funds classified by ASISA as South African portfolios2) it is essential that the managers demonstrate excellent, fully integrated investment capabilities, with local and offshore assets managed holistically. While some managers may outsource the offshore holdings in their South African portfolio, we believe it vital they are managed with full oversight by the South African fund’s portfolio manager(s), rather than as a bolt-on portfolio of vanilla assets benchmarked to a global index. Bolt-on, at best, does not enhance the risk/return tradeoff and at worst leads to unintended positions within the fund.
The impact of capital gains tax (CGT), often overlooked
For discretionary investors, even if a warning signal has triggered, a further consideration is the early payment of CGT when making portfolio changes. Or is it? While often considered, the CGT impact is seldom quantified. However, this is an important exercise because when an investor disinvests intra-term and pays CGT there is the compounding opportunity cost of the tax paid. Simply put, an investor in the maximum marginal tax bracket who realises a capital gain of a R100 000 pays CGT of R18 000 (if he has already used his annual capital gains exclusion of R40 000). The opportunity cost to the investor is then the difference between the future growth on the full R100 000 (if he did not realise the investment) versus the growth on only R82 000. This opportunity cost is often missed in the investment planning process because the CGT on a portfolio rebalance is generally paid later in the year, and often from an investor’s other liquid assets.
Quantifying the CGT cost of portfolio changes
Now that we understand that the early payment of CGT may carry an opportunity cost, we have tried to answer the following question; “If an investor switches out of fund A and into fund B at some point during their investment term, what additional return is required from fund B to compensate the investor for the early payment of CGT?”
The answer to this question is not straightforward and depends on multiple factors, which include the returns and profile thereof delivered by fund A and B, the investor’s investment time horizon and at which point in the investment time horizon the investor decides to switch.
As an example, let’s compare the experience of two investors, Jack and Jill who invest a similar amount in fund A at the same time, and have an investment time horizon of 10 years. Fund A delivers a consistent return of 10% p.a. and Jack remains invested for the full 10 years, at which time he disinvests and pays his CGT liability. Jill, on the other hand, identifies one of the triggers detailed above and decides to switch out of fund A after 5 years. After paying CGT, Jill invests the remainder of her proceeds into fund B. Table 1 sets out the excess return per annum that fund B must deliver over the following five years so that Jill has the same fund value as Jack at the end of the 10-year term.
Table 1: Excess return required from fund B
The table above shows that, for an annual return of 10% p.a. from fund A, fund B needs to produce an additional 0.60% p.a. so that Jack and Jill finish on the same fund value after 10 years. This difference in return represents the opportunity cost of paying CGT after 5 years.
Fairly intuitively, our analysis indicates that:
• The required additional return from fund B increases as the return from fund A increases (as seen in the table)
• The longer the investment time horizon the greater the additional return required from fund B (e.g. doubling the investment term to 20 years increases the excess return required on fund B from 0.60% p.a. to 0.81% p.a.)
• The earlier into the investment time horizon you switch, the lower the additional return required from fund B and vice versa
The CGT impact of making changes to an investment portfolio should be carefully considered and quantified. The CGT impact can set a portfolio back and should therefore be evaluated against the expected benefit of the portfolio change. Given the multiple factors that will affect this decision, we strongly recommend that you consult with a qualified financial advisor and seek expert tax advice, as required.
For longer-term, higher marginal tax-paying investors it may prove beneficial to hold their underlying local investments in the Investec IMS Access sinking fund policy and for offshore investments in the Investec GlobalSelect Access sinking fund policy, as they will benefit from the lower CGT effective rate of 12% (for maximum marginal taxpaying investors).
All information provided is product related, and is not intended to address the circumstances of any particular individual or entity. We are not acting and do not purport to act in any way as an advisor or in a fiduciary capacity. No one should act upon such information without appropriate professional advice after a thorough examination of a particular situation. This is not a recommendation to buy, sell or hold any particular security. Collective investment scheme funds are generally medium to long term investments and the manager, Investec Fund Managers SA (RF) (Pty) Ltd, gives no guarantee with respect to the capital or the return of the fund. Past performance is not necessarily a guide to future performance. The value of participatory interests (units) may go down as well as up. Funds are traded at ruling prices and can engage in borrowing and scrip lending. The fund may borrow up to 10% of its market value to bridge insufficient liquidity. A schedule of charges, fees and advisor fees is available on request from the manager which is registered under the Collective Investment Schemes Control Act. Additional advisor fees may be paid and if so, are subject to the relevant FAIS disclosure requirements. Performance shown is that of the fund and individual investor performance may differ as a result of initial fees, actual investment date, date of any subsequent reinvestment and any dividend withholding tax. There are different fee classes of units on the fund and the information presented is for the most expensive class. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down. Where the fund invests in the units of foreign collective investment schemes, these may levy additional charges which are included in the relevant Total Expense Ratio (TER). A higher TER does not necessarily imply a poor return, nor does a low TER imply a good return. The ratio does not include transaction costs. The current TER cannot be regarded as an indication of the future TERs. Additional information on the funds may be obtained, free of charge, at www.investecassetmanagement.com. The Manager, PO Box 1655, Cape Town, 8000, Tel: 0860 500 100. The scheme trustee is FirstRand Bank Limited, PO Box 7713, Johannesburg, 2000, Tel: (011) 282 1808. Investec Asset Management (Pty) Ltd (“Investec”) is an authorised financial services provider and a member of the Association for Savings and Investment SA (ASISA). A feeder fund is a fund that, apart from assets in liquid form, consists solely of units in a single fund of a collective investment scheme which levies its own charges which could then result in a higher fee structure for the feeder fund. The fund is a sub-fund in the Investec Global Strategy Fund, 49 Avenue J.F. Kennedy, L-1855 Luxembourg, Grand Duchy of Luxembourg, and is approved under the Collective Investment Schemes Control Act.
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