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Pathfinder Monthly Commentary: Death and taxes – how certain are they?

Understanding tax implications for investors is vital when considering options.

Wednesday, June 5th 2013, 8:30AM 30 Comments

by Pathfinder Asset Management

In 1789 Benjamin Franklin famously wrote “in this world nothing can be said to be certain, except death and taxes.”  However tax rules are not always certain - the real world application is often unclear.  This month we look at tax issues for investors around PIE and Australian Unit Trust structures.  We recognise that for most sane advisers, fund managers and investors, tax is not an exciting topic – so we’ll keep this commentary short and succinct.

There are a number of factors to consider when comparing the efficiency of PIE and Australian Unit Trust (AUT) structures for investing in international shares.  Before we jump into the tax considerations, here is a summary of some of the key non-tax factors:

  • Currency exposures:  Australian Unit Trusts are typically not built for NZ investors – any currency hedging will be for the benefit of A$ investors.  Be aware of underlying currency exposures (do you want un-hedged A$ exposure in the portfolio?).
  •  Compliance costs matter:  PIEs are a clear winner over AUTs on the tax compliance front. PIE income does not need to be included in a tax return – a significantly lower compliance burden for investors.
  •  Watch out for the “fund of funds” structure:  Many PIE funds investing in international shares do not hold any shares because they feed into an offshore share fund.  This will introduce another layer of costs and may also mean that some of the inefficiencies of offshore structures (that we mention below), also apply to that PIE fund. 

Below we consider 4 of the tax implications of PIE and AUT structures.  While some may appear confusing and complicated, please note there are likely to be other tax issues that we have not considered here!

1. Australian Unit Trusts (AUTs) and the hidden withholding tax drag

AUT are a popular investment vehicle for Australian fund managers distributing product into NZ.  Many investors recognise the positives of AUTs such as the ability to fall under the Foreign Investment Funds rules (see paragraph 2 below). 

However what is not widely recognised is that AUTs can be inefficient for NZ investors where the AUT holds international shares.  This is because dividend payments to Australia will likely have withholding tax deducted but a NZ investor does not get a corresponding withholding tax credit.  This means the NZ investor can effectively suffer tax twice on the international dividend income (once with the withholding into Australia and again in NZ).  International shares held through a PIE structure do not face this leakage.

Let’s try and quantify the expected tax leakage in an AUT.  The standard US withholding tax rate for NZ and Australian investors is 15%.  If a NZ investor holds US shares directly or via a PIE managed fund then US tax is withheld on dividends but the NZ investor receives a credit for the 15% tax.  This is quite different to a NZ investor investing in an AUT which in turn holds the US shares.  In this case the AUT receives the 15% tax credit but cannot pass it on to the NZ investor.  Using the current dividend yield on the popular US$12 billion iShares Dow Jones Dividend ETF (DVY) we look at the potential tax leakage of an AUT:

Investing in international shares through an Australian Unit Trust rather than a NZ PIE may have a cost - the inability of NZ investors to receive value for offshore withholding tax on dividends.  The actual cost will depend on several factors including the dividend yield, withholding rates and application of the FIF rules (see para 2 below).  But in the above example (based on a broad iShares US equity ETF) the cost to NZ investors can be 0.37% per annum. 

2. The FDR vs FIF debate – the AUT advantage

A different strand of the AUT vs PIE tax efficiency discussion relates to NZ investors in an AUT falling under the Foreign Investment Funds (FIF) tax rules.   In very simple terms the FIF rules allow an election for tax on a Fair Dividend Rate (FDR) or Comparative Value (CV) basis.  The FDR calculation is essentially a “wealth” (or asset) tax which assumes income of 5% is generated every year – whether or not the investment goes up or down and whether or not dividends are actually paid. The CV basis is a more intuitive “growth” (or gains) tax where tax is levied on the actual gain or loss each year (being capital gains plus dividends).  If a share goes up 7% in a year and a dividend of 3% is paid, then on a CV basis taxable income is 10% and on an FDR basis taxable income is fixed at 5%. 

The CV basis is preferable if the annual gain is <5% while FDR is preferable if the annual gain is >5%.  Unlike AUTs PIE funds holding international equities are taxed only on a FDR basis.  PIEs do not fall under the FIF rules and so cannot elect to be taxed on a CV basis.

The expected cost of this for PIEs will depend on the assumptions used.  We have seen work on this by one of NZ’s main brokers using the key assumption that international equities fall in one of three years and gain by 5% or more in two of three years.  Their calculation produced a 0.30% p.a.  potential tax inefficiency of the PIE against the AUT structure. 

3. Australian Unit Trusts and the non-deductible fund manager fee

But wait, there’s more!  If an AUT is taxed on an FDR basis then NZ investors are assumed to have income at 5% of the opening value of the investment.  In this case there is no tax deduction for fees of the Australian fund manager.  By contrast if the investor had held the same offshore shares through a PIE fund, then manager fees are tax deductible. 

This tax inefficiency for Australian Unit Trusts applies only when FDR is used.  Let’s try and quantify this for a $100 investment in US shares using the following key assumptions:

• The Australian fund manager (AUT) and NZ fund manager (PIE) each charge fees of 1.50% p.a.
• The offshore equity investment goes up by $10 for the year (10% on $100 invested) so FDR calculations will apply to both the AUT and the PIE

Let’s assume that in one of every 2 years markets go up by more than 5% (so an AUT investor would elect FDR treatment) and in one of every 2 years markets fall (so an AUT investor would elect CV treatment).  This means that in one of every 2 years the NZ investor in an AUT would suffer a cost of 0.67% through being unable to get a tax deduction for the Australian fund manager’s fees.   If (based on our assumptions) FDR applies in one of every 2 years, the Australian Unit Trust has an average tax leakage of 0.33% per annum because the NZ investor cannot get a tax deduction for the Australian fund manager’s fees.

4. The tax rate is capped in a PIE at 28%

This tax advantage of a PIE is well recognised – a high rate investor’s tax is capped at 28% in a PIE against potentially paying the highest marginal rate (33%) when investing in an AUT.

5. Final thoughts

What does this tell us?  Tax can be a minefield to understand and also a black hole for adviser fees.  The only certainty about tax is, one way or another, it has to be paid. Some quick thoughts:

Focus on the after tax return.  Fund managers report returns before tax.  Banks advertise deposit rates before tax.  Dividend yields on shares are published before tax.  Be aware of the tax cost or benefit (normally a cost!) as the after tax return is the real investing experience.  Note that the tax efficiencies/inefficiencies set out in paragraphs 1-4 above do not show through in pre-tax fund returns (they only impact post tax returns).

The tax differences between PIE and AUTs are complex:   PIEs and AUTs are popular legal structures that both have distinct (and complicated) subtleties around tax treatment.  PIEs are criticised for only having FDR tax on international equity investments but also benefit from a tax rate capped at 28% (vs 33% for AUTs).  What is not widely recognised is that AUTs also have tax inefficiencies such as leakage from the loss of withholding tax credits and the loss of tax deductions on manager fees.  Complex?  You bet, but before investing in international funds, study and challenge all aspects of tax treatment.

Compliance costs and currency hedging matter too:  So which structure (PIE or AUT) is preferable?   PIEs are a clear winner over AUTs on the tax compliance front - PIE income does not need to be included in a tax return – a significantly lower compliance burden for investors.  PIEs are also likely to have currency hedging suited to NZ investors (unlike AUTs which are typically built to suit Australian investors).

Do not ignore tax effects.  A comparison of the tax efficiencies (benefits) and tax inefficiencies (costs) for both AUT and PIE structures is complicated – but important. While tax efficiency should never be the principle driver of any investment decision, it remains a key consideration. 

John Berry
Executive Director

Pathfinder Asset Management Limited

Pathfinder is a fund manager and does not give financial advice. Seek professional investment and tax advice before making investment decisions.

Pathfinder is an independent boutique fund manager based in Auckland. We value transparency, social responsibility and aligning interests with our investors. We are also advocates of reducing the complexity of investment products for NZ investors.

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Comments from our readers

On 5 June 2013 at 2:20 pm Anthony Edmonds said:

Good article. You write well (easy to understand.......unlike me!).

To build out a couple of the things you have noted:

Firstly the tax inefficiencies (relating to the withholding tax and non-deductability of fees) that you talk about in Australian Unit Trusts occur in all offshore fund structures (it is not limited to Australian Unit Trusts). Accordingly this is happening in things like the listed UK trusts and other offshore funds that get widely used in the NZ market.

The extent to which the withholding tax slippage occurs (in any offshore fund) is also a function of the extent to which an offshore manager might be able to reclaim some of this on behalf of the fund. Accordingly, a Kiwi investor needs to dig a bit to get the right answer regarding this.

A PIE that invests into offshore fund structures may also incur the tax slippage outlined above (as the PIE is just like any other NZ tax resident). Note that just because a PIE does invest in offshore fund structures, don't simply assume that it does incur this slippage (I am a bit bemused in terms of how an adviser or retail investor researches this type of issue, as few/no research houses seem to). Anyway - you make a great point that these issues need to be researched and understood. I strongly recommend that people ask managers to explain how the tax aspects of their funds work,and to get them to put this in writing. If the managers won't, I would assume the worst!

You missed one of the key advantage that FIF has, being that individuals only pay tax on the value of their portfolio was at 1 April. Accordingly contributions and gains (made during the year) aren't taxed. This can have a significant impact in favour of the FIF (which in turn is a function of the level of contributions and returns). From my work in this area, this factor (when combined with the ability to not pay tax in a falling market) is what will swings things in favor of FIF funds for many individuals (but this is actually extremely dependent on the specific circumstances of each individual).

In an AUT any Australian sourced income normally has tax slippage on it (so look out for AUTs with any Australian exposure….and note that few Australian's will ever explain this to you, as I simply don't think they get this about their own funds).

Against all of the benefits in favour of FIFs, it is easy to come up with ways in which some retail investors could structure all their affairs to get huge tax advantages from using PIEs (again – this is a function of their specific circumstances).

The global share tax rules in NZ are overly complex. The disclaimer that investors should seek their own tax advice is basically nonsense – as there are few tax experts in the country you could actually go and get any proper advice regarding this (if you know of tax experts who are right on to all this stuff, then call me – as I am always keen to know who is out there that we can talk to and share ideas with, to complement the experts we use). Also, these issues don't seem to form part of any sort of research rating process, so again it is up to investors to research this. The tax implications/outcomes can be extremely significant, so I don't think one can turn a blind eye to this stuff.

Also, the ability for Australian managers to push product into the NZ market (under the Mutual Recognition regime) without actually addressing or explaining this stuff for Kiwi investors, needs to be addressed. Again - the disclaimer that they make that Kiwi's should seek their own tax advice is basically nonsense when you come to appreciate how complex an area this is. In my mind the onus should be on the offshore manager to explain it, as they are best positioned to understand the tax implication of their products for Kiwi investors.

And as a final thing, I like your suggestion that investors should focus on after tax returns. I guess I read this as being that they should understand all the tax implications of any investment they make. The point I would make here is that under PIE, there are no net returns for funds anymore (as tax is done at the individual investor's level). I can't imagine being able to get a "reg 30" sign-off from my directors for a "net of tax return" for a fund (given that the fund does not have a net of tax return, and the assumptions that one would need to make to calculate this). It is probably something that could be done on annual basis.

Anyway - good article John.
On 6 June 2013 at 11:06 am Brent Sheather said:
The best way to look tall is to stand by a short person! Similarly the best way to make local PIE funds that invest in international shares look reasonable is to compare them with Australian unit trusts. A more relevant comparison would be with UK investment trusts and genuinely low cost ETF's. If you factor in annual management fees to the equation PIE funds look pathetic and you could argue that anyone who recommended them wasn't putting their clients’ interests first. Now let the squealing begin!
On 6 June 2013 at 1:13 pm John Berry said:
Thanks for your comment Brent. I chose AUTs as a comparison to PIEs for simplicity. However, for the record, your UK listed investment trusts share the same tax inefficiencies as AUTs - withholding tax credits on dividends are lost and if FDR is chosen then you do not get a deduction for management fees.

I think your criticism of advisers who don't use UK listed trusts is largely unfounded. Lets take an example - if you put clients into RIT Partners at the lows during the GFC (end of Feb 2009) then their total return incl dividend reinvestment would have been 1.29% per annum in NZ$ over the 3 years. They missed out on the 11.3% p.a. return in Sterling terms, that is, they missed out on 10% per annum! How can investing in UK trusts without managing the currency be in a client's best interests?
On 6 June 2013 at 2:14 pm Anthony Edmonds said:
Exactly Brent.

Both UK Investment Trusts and ETFs have the tax slippage that John is talking about on fees and dividends - which is why NZ investors and their advisers need to think through this before investing.

The point that I was making (poorly) was that while FIF funds generally win out for individuals, in some cases PIEs will, and this in turn is a function of the individual's circumstances.

If I was an adviser I would want to have both FIF and PIE global share options in my kit bag, which from what I have seen is a pretty common approach by many advisers.

To argue that one will win out over the other in every case for retail clients is not sensible, as this is actually a function of the specific individual client's circumstances. I can show you examples of where (for an individual) going for the FIF option makes absolute sense, and equally examples where going for PIEs will save them a whole lot of tax (and we are talking about hypothetical examples involve decent amounts of money....and these are close to home, as if you are advising someone like me, then the answer would be FIFs, however, for the wife you would need PIEs).

If you would like more on how this works, flick me an email, as I have more information on this and are happy always to share it.

To me, to argue that the right answer is always FIFs, or the right answer is always PIEs, should actually be a bit of a warning light, as it says that the circumstances of individual clients' aren't being considered.

At the heart of this is the real problem, being that when it comes to individuals, the tax rules for global shares are way too complex.
On 6 June 2013 at 3:30 pm Brent Sheather said:
Thanks John and Anthony. I agree with some of your points but I think the bottom line is that the fees are much lower for the investment trusts I use and certainly for the ETF’s. If we start with an average yield for the world stock market of 2.5% and knock off 10 basis points for Vanguard’s fees then 1.65% in FDR tax that gives me income of just under 1%. Do the same numbers for a managed fund with an MER of 1.5% and my cash flow from my international share fund is … negative! Now how many financial advisers do you think point this out to retail investors – my guess is not a lot.

John you do yourself a disservice by blatantly data mining. As far as currency is concerned my clients when they consider their pension, their house, their NZ bonds and goodness knows what else have more than enough exposure to the NZ dollar so hedging their overseas bonds is ridiculous and illogical although I must admit it has been profitable for a while.

Last but not least virtually all my clients have family trusts so the tax advantages of PIEs are more than offset by their high fees. I only use PIE’s for NZ shares and property and even a US listed ETF investing in NZ compares well with a number of local PIE’s so for my clients the right answer is always FIF. What is more I have a nice tax refund apparently in the mail from IRD thanks to being able to use comparative value a year or so ago. One thing I do agree on is that the tax rules for global shares are stupid. Regards Brent
On 6 June 2013 at 4:51 pm John Berry said:
Brent - I am pleased that my monthly commentary has stimulated some debate - great.

I am, however, concerned you hold me out as a "blatant" data miner. To be fair to investors in RIT I chose the start point as the lowest price since the GFC and calculated to end of May 2013 - if I was a data miner I would have chosen a higher (pre-GFC) price like October 2007. But even pre-GFC supports my point - from Oct 2007 your RIT holders have experienced a -3.8% pa loss to date while if they had currency hedged they would have made 2.4% pa profit. If your point is that 3 or 6 years is not long enough then lets look since RIT inception (May 1989). Unhedged returns in NZD +9.3% pa but NZD hedged +10.8% pa (and that doesn't include the forward point benefit...)

You cannot accuse me of data mining simply because you don't like the answer from the data. The answer is that in reality your fee argument has been swamped by the currency.

You seem to prefer the discussion to be about fees - I am happy to write about fees in a future month. For now I can give you a rough comparison of the low fee ETF you mention vs Pathfinder's World Equity Hedged Fund (PIE). Our PIE return would be: underlying ETF fees -0.20% + div yield 2.5% minus Pathfinder after tax MER 0.91% + forward points benefit 1.8% minus FDR 1.40% = 1.79% in total. Without wanting to be labelled a data miner (again) that does seem to be slightly better than your unhedged ETF after tax return of 0.75%.

I understand your point that clients may have NZ bonds, NZ equities, a house in NZ etc and so a "home country bias". I totally agree with you that an adviser must take this into account for each client to determine an appropriate currency hedge for that individual. Where I can't agree with you is that a "zero" currency hedge on international equities could possibly be the right answer for every investor in NZ. It may be right for some but a "one size fits all" 100% unhedged rule does not account for each investor's individual circumstances.
On 6 June 2013 at 5:33 pm brent sheather said:
My point about data mining was that RIT doesn't make up 100% of most people's intl equity portfolios..and barely 5% of that of PAM's client base..which is a pity because long term it's been a great performer.

i've owned it since 1990.

On your last point I agree..there is probably 5% of the NZ retail investment universe for whom hedged international equity exposure makes sense.

I would be interested in your thoughts about what percentage of retired retail don't have a house, a pension in NZ$, a NZ bond portfolio, a NZ property portfolio etc..

Maybe its 6%?. It seems to me that fwd points sees mum and dad selling their insurance, not being aware of it and most of the fwd points going in fees anyway. Right !
On 6 June 2013 at 8:43 pm brent sheather said:
One more thing I have just noticed... why are you using an after tax MER with a pre tax fwd points and a pre tax dividend yield..clearly incorrect.

Either everything is calculated on a pre tax basis or an after tax can't mix and match to achieve an objective.

Rgds Brent
On 6 June 2013 at 9:42 pm Anthony Edmonds said:

My wife doesn't work (pun intended).

Key here is that if she invests $950,000 in a global share PIE and and this was her only investment/income, then her PIR is 10.5%.

Based on a PIR of 10.5%, and FDR income of 5%, she would pay tax of 0.525%.

Paying 0.525% of tax on $950,000 results in roughly $5,000 in tax. In my books this beats paying the 1.65% of tax - being roughly $15,500 in your example (which I guess is what would happen if the money was put into a family trust and taxed at trustee income).

Now to be fair, she might not choose global shares (and choose something like fixed interest), but she would need to get her own advice about this (I gave up trying to give her advice after the first time she drove me to the pub back in 1989). That said - I would be pretty annoyed if someone gave her/us advice and didn't highlight the benefits involved in this stuff.

The family trust is good for protecting assets (which is why we have one), but it is not the be all and end all when it comes to investing efficiently (and just because one has a family trust, why would they feel obliged to stick everything in it?).

This all links back to my early point, being that I think advisers need a range of options in their tool kit, as the solutions recommended will depend on the circumstances of each client (and pleasingly lots of advisers seem to do this in my experience). Like you I am a fan of FIFs for global shares, but I know they aren't the right answer for all clients all of the time. The right answer is a function of the individual circumstances of each client - which is where the really complexity begins (especially if you throw Code Stand 6 type thoughts into the ring).

It is good you agree that the tax rules for global shares are overly complex. I am looking at putting together a group to talk to the Government/IRD/FMA about this, and I would be happy to talk to you about joining in (we could use the above exchanges as evidence of the confusion that exists!).
On 7 June 2013 at 9:09 am Brent Sheather said:
Hi Anthony

Thanks for that and that certainly is a major saving in income tax. However my guess is that there are not many local PIE’s which don’t hedge to some extent their fx exposure so that is a major reason for me not to use PIE’s. Hedging fx is obviously not prudent on international shares if 90% of one’s assets are in NZ$ including the present value of one’s pension/super.

Then there is the issue of annual fees which generally are much, much higher with PIE’s. In order to offset the tax impact on your best case scenario they only have to be 1% higher and this isn’t factoring in the other benefits of FDR which you elaborated on initially.

The bottom line however is that I completely agree we shouldn’t be wasting our time talking about tax because there should be an even playing field. The key variable as numerous academics point out is fees, everything else is noise and unreliable noise at that. Regards Brent
On 7 June 2013 at 10:21 am Cam Millar said:
As always I have some sympathy for Brent's argument ... but only some.

Currencies tend to be mean reverting - so in the "medium" term it does not really matter if you fx hedge or not. In the longer run fx can certainly trend, but it happens relatively slowly.

But in the short run, fx moves can have a large impact on the value of offshore assets.

Most balanced fund managers (including I presume the UK pension funds that Brent extols elsewhere) tend to use a mix of hedged and unhedged offshore assets. This tends to reduce the volatility in short term returns without changing the medium term return greatly.

Now Brent is right that if you include all a person's assets (their house, future value of their Govt pension), then you may prefer unhedged offshore investments (and potentially no NZ bonds or shares at all) to get the overall non-NZD exposure to the correct level. That does means knowing correlations between their assets and other financial assets.

But ultimately I am not sure all (or even many) clients think that way. Few think of their house and pension as just another financial asset.

If they focus on the portfolio you are managing as a seperate bucket, and you have a 100% unhedged policy, they may get worried by the volatility they are seeing. Volatility you can reduce by some fx hedging.

Ultimately we are trying to get a portfolio that matches the objectives of a particular client. Hedging part of their offshore exposure may (or may not) better achieve their objectives. It is not certain it should be one way or another - it depends on the client and how they think about their assets.

I think there are valid reasons to consider hedging - that then leaves the complication of where you can find a low cost NZD hedged product (yes John and Anthony you are both too expensive), and the complex tax issues raised in the article on whether you would prefer a PIE or FIF structure.
On 7 June 2013 at 10:37 am John Berry said:
Brent, this is an interesting discussion as we are both approaching from a data based perspective – but ultimately our interpretation of the data may diverge. I think we’ll have to agree to disagree about a few issues.
A couple of things I’d like to clear up – firstly, data mining. I chose RIT to illustrate different hedged & unhedged returns because that’s the trust most widely mentioned by advisers. It doesn’t matter which trust we choose, the result is the same – over the last 25 years holding a hedged UK listed trust did better than having it unhedged. Obviously actual return numbers are different for each trust but the relativity between hedged & unhedged is the same. It’s not just RIT where unhedged returns underperformed hedged - I am not mining the data.

Secondly with my calculation of after tax returns for the PIE I have shown the forward points on an after tax basis. Global share PIEs overhedge to provide a 100% after tax hedge for a 28% PIR. The full maths is {(1.8% / (1 - 0.28)} x (1 – 0.28). Sorry but I thought it was easier to just show the post-tax number (1.80%). However you are right to the extent I should have pointed this out for those unfamiliar with hedging.

You note “there is probably 5% of the NZ retail investment universe for whom hedged international equity exposure makes sense”. Where did you get that number from? I have sympathy with the view that unhedged offshore assets act as a hedge for risks that may hurt the NZD - but structuring a portfolio (by being always unhedged) can be a very expensive way to diversify the low probability of a high impact event. One concern is that investors do not actually measure the implicit cost of this protection – for a start you have the benefit of the interest rate differential (very significant over 20+ years) plus significantly lower realised portfolio volatility. The job of a fund manager is, as Anthony says, to provide a range of investment tools that meet specific risk metrics for advisers. I can’t tell advisers how many clients need hedging, or need international equities or need NZ bonds…. Its an adviser’s role to understand their client needs and product available.

Finally, I think you have framed your question on NZers and hedging wrongly. The question is not “how many NZ investors need currency hedging”, the question is “what is the right hedging ratio for each NZ investor?” The answer may be 0% (fully unhedged, as you prefer) or 100%, or 50% or something else. As a guide the NZ Super Fund, probably the most sophisticated long term investor in NZ, operates a minimum 50% hedge at all times and can go up to 120% hedged…. Advisers should review their client’s needs and financial position and decide where they fit on the 0% to 100% hedging spectrum. I have no problem at all with advisers deciding that 0% hedged (fully un-hedged) is right for their client – I just urge advisers to include the hedging issue as part of their decision making process. After all, to ignore the possibility of hedging is to make a very active decision that 0% is the appropriate ratio.
On 7 June 2013 at 11:49 am Wayne Ross said:
Thanks for the article John. It is overly complicated alright and in my view unfair.

Focusing on the after tax return is relevant but I agree with Anthony that this is more so at an individual investor level rather than a product level. The reality is very few investors are paying 33% and given most have other non-PIE income sources there is really no additional compliance burden. So its horses for courses.

One area you haven't touched on is the tax drag of currency management within a PIE vs a FIF asset. This is material.

Finally fund size/liquidity and distribution policies can also impact on effective tax efficiency and are relevant when comparing PIE vs offshore options.

On 7 June 2013 at 11:59 am Bill said:
Offshore shares in PIES vs other vehicles

In those years where a loss occurs, maybe 1 in 5 years, the PIE stills pay FDR tax at 5% (good thing may investors can't see it).

Whereas the others can use CV or if loss, not pay tax at all.

Seems to me the small advantage you get from the PIE in +5% years is negated when there is a poor year.

I would rather concentrate on fund selection as a priority and put tax a distant 2nd.

However must say I respect John Berry , he does good work.
On 7 June 2013 at 2:03 pm Brent said:
Hi again John

On your after tax returns for the PIE that’s fine if you have used the forward points on an after tax basis but that dividend yield you have used is definitely pre-tax, isn’t it!

The 5% of NZ retail investors’ figure was me just being humorous but as most NZ retail investors have a house and a pension and a NZ bond portfolio it makes sense for them to have an unhedged international portfolio because just by living they are short US dollars. Remember that milk, meat, butter, oil, just about every commodity is priced in US dollars and if the NZ dollar falls NZ farmers are going to say “I can sell that 1 litre bottle for a higher price in the world market place than I can in NZ therefore the NZ price needs to go up”. The logical way you hedge this short position is to own US dollar assets so hedging, to me, is ignoring that risk therefore risky.

My cynical view is the only reason fund managers hedge their international equities is to pick up those forward points which helps in the performance comparisons but if you think about it logically it is a risky proposition given that Mum and Dad, living quietly in Tokoroa, are short US dollars without perhaps knowing it.
On 7 June 2013 at 3:01 pm John Berry said:
Hi Brent - re the tax on the dividend - you might be getting your FDRs and CVs mixed up. Under FDR the pre-tax and post-tax number for the dividend should be the same (the dividend itself is not taxed).

Cam / Wayne / Bill, thanks for your comments. Wayne, I had intentionally left the FIF vs PIE tax treatment of the hedge out - this is really an inconvenience for pre-tax reporting not a financial cost for investors. By overhedging the PIE (see my comment at 10:37 today above) we arrive at the same post tax result as FIF. And to complicate things further a tax change to fix this is in process .... it just seemed one complication too many for an already complicated article!

On 7 June 2013 at 6:35 pm brent sheather said:
er..on reflection I think I agree with your calculation! But...still think hedging is the wrong thing to do for all my clients and that given that forward points and fdr may well be transitory that fees dominate the decision..thats how I interpret the obligation to do the right thing.
On 10 June 2013 at 12:49 pm John Berry said:
Brent - thanks. Three quick final points:

1) I think we probably agree on more than just the div calculation! I can't argue with your point that "hedging is the wrong thing to do for all [your] clients" - as long as you consider on a client by client basis whether hedging may or may not be appropriate then you are "doing the right thing" as you put it. By contrast I view a fixed blanket rule that hedging is never appropriate would be "doing the wrong thing".

2) Re your point that FDR and forward points "may well be transitory" - lots of things may be transitory - such as no gift duty in NZ, NZ inflation under 10% pa, growing demand worldwide for milk/protein - are you suggesting we organise all our affairs to avoid/ignore every influence that "may well be transitory"? Could be tricky!

2) Lastly - in an earlier comment you mention that taking the forward points benefit (i.e. hedging) is selling your insurance on the currency. But you can also think of this in the reverse - not taking the forward points (not hedging) means you are buying insurance - the cost of your insurance (cost of being unhedged) is 1.8% p.a. Without any judgement on whether hedging is the right or wrong thing to do, should investors be made aware of this insurance cost?

On 10 June 2013 at 4:30 pm Realist said:
The hedging differential of around 1.7 – 2 % pa over a forecast ten year period for global shares should make it very attractive to have a significant portion of a client’s international shares hedged to the NZ dollar. There are funds available where there is no additional fund manager fee incurred. Implicit within this argument is that you would be unhedged if you believe that the NZD will fall in value against a basket of currencies by 17 – 20% over the next ten years. The position of least regret is usually considered to be an overall 50% hedge.

Of course, advisers who only use Listed UK Investment Trusts and ETF’s do not really have the ability to take advantage of currency hedging, unless they enter into hedging contracts which will come at a cost to the investor. There would also be additional costs associated with more complex accounting, and also potential tax liabilities associated with any currency gains or losses.
On 10 June 2013 at 4:54 pm brent sheather said:
Realist I'm interested in your comment "there are funds available where no extra fund manager fee is incurred". I use the vanguard world index fund with an mer of about 15 basis points..i.e 1% less than most hedged options. Where can you get a hedged pie at that price..I'm thinking nowhere !!
On 11 June 2013 at 8:29 am Realist said:

You could try the Vanguard® International Shares Index Fund (Hedged) - NZD Class but it is not a PIE.

On 11 June 2013 at 9:28 am Wayne Ross said:
John I am not sure effectively leveraging the hedge exposure is a fair comparison from a risk or return perspective? That said, I note your comment that the tax treatment under the financial arrangement rules is changing so that issue should fall away which is great.
On 11 June 2013 at 11:10 am brent sheather said:
Thanks for that but there is an a $500,000 min and the Mer is twice that of Vt.
On 11 June 2013 at 1:45 pm Realist said:
Wrap account platforms overcome the minimum dollar threshold amounts. No doubt you will in typical fashion start going on about fees again. Keeping fees low is not the be all and end all. The platform costs are well below the benefits that your clients would obtain.
On 11 June 2013 at 2:48 pm brent sheather said:
Yes well those benefits represent my clients selling their diversification insurance. When a certain Harley Davidson riding bishop is the prime minister and we are 20c against the Ozzie I will remind you of this conversation..from the gold coast. Rgds Brent
On 11 June 2013 at 8:38 pm Anthony Edmonds said:
John - Do you know the proposed date for introducing the ability to get currency hedging taxed on the same basis as the underlying global shares (in a PIE)?

We have a crazy position in the market where the asset allocation of many diversified funds (like KiwiSaver funds) are only right for one group of tax payers, like those on 28% PIRs. This in turn links back to my point about the overly complex tax rules that we have (so sorting this out would be at least a step in the right direction).

While I agree with your views (John) about the positive returns from currency hedging, I also agree with Brent's view that there are benefits from holding foreign currency exposure within a portfolio. For me personally the fact that there is a "cost" associated with holding global currency is fine in my books, as this is the insurance premium I pay for hedging against the risk that something bad happens to NZ. The fact I essentially over-pay for this insurance (being the additional positive return that I would have otherwise received each year from hedging) is fine in my books, as I just put it down next to the other forms of insurance that I have over-pay for. That said, this is only a personal view of my own situation, as I could roll out various experts to argue the merits of fully hedging everything, and all of them are far more qualified to comment than me.

Brent - You have to get past the "FIF passive funds always" win argument, as this might be the case for some individuals, but it is not the case for all of them. You will have clients who actually benefit from using PIEs, and if you are passionate about getting a well structured cheap passive PIE, then I suggest you do research on this by asking around (I am aware of the existence of at least one possible option in the NZ market, but I am not about to promote the provider's funds for them).

Also the FIF/PIE/active/passive issue is far more complex than you paint it, as it gets into areas like the tax deductibility of management fees, and ability for NZ investors to get any tax benefit in relation to the withholding tax on the underlying dividends, combined with the circumstances of the underlying individuals. To argue that one answer wins for all individuals indicates a lack of proper analysis and consideration of these factors. I am happy to spend any amount of time with you (and any other advisers who might be interested) working through this to demonstrate what I mean by using different examples of "hypothetical" individuals (who in-turn would meet your threshold to become a clients through having lots of money to invest). The key point here is that I think recommendations made to any single client should take into account their personal circumstances and situation, rather than being based on what might right for the majority of clients.

Lets all agree that the tax rules for global shares are overly complex and get on and do something about it as a group.

John - Back to you, as a big hand in regards to getting so many comments and raising such a tropical issue (pun intended once again)!
On 12 June 2013 at 11:06 am Brent Sheather said:
Hi Anthony

Thanks for your comments and yes well done John for raising this issue and informing most readers including me as to the nuances of FIF. Having said that I still feel that all the tax implications are really just noise and the big issue is that investors should match their liabilities with assets. As I have said before – 7th June at 2.03 pm – just by living I am short US dollars so a sensible person would hedge this exposure by owning US dollar assets. For the record half of Private Asset Management’s equity exposure is via actively managed funds because that is what best practice is overseas and everybody has an obligation to pay to keep the market efficient. Finally I do acknowledge that there is probably some retail investor out there for whom a hedged position makes sense … but I am yet to meet them. In addition I think the academic research which says that hedged assets have lower volatility ignores the big issue for New Zealand investors and that is matching liabilities with assets. Regards Brent
On 13 June 2013 at 8:30 pm Anthony Edmonds said:
Thanks Brent.

The article was titled "Death and Taxes", so it is good to see how much "noise" the tax aspects created (as there hasn't been too many comments or debate regarding death).

I think that tax is a big consideration in terms of recommendations to a specific client, and not as you say "really just noise".

A huge amount of time, effort and expense goes into the area of understanding the tax implications of different investments within the wholesale segment of the NZ investment management industry. Given that both wholesale and retail investors share a common bond of being NZ tax payers, I think that the focus should be the same in both industry segments. Like fees, tax has a direct and immediate on the impact to the end investor, so should be given the same level of attention.

Note that any portfolio optimisation (and let's hope I haven't just invited 29 additional comments from all the crazy believers in "sub-optimal portfolios" - as they strike me as people who need to think about what they are saying pretty carefully!) should be done on a net of tax basis. A simple thing to think through in regards to this is why NZ tax payers have such a high weighting to NZ shares (where as tax-exempt clients like community trusts tend to have lower weightings), but let's leave this for the next round of debate and discussion.

Put a different way - I agree 100% with your comment that the key is matching assets and liabilities. This needs to be done on a net of tax basis. I can imagine that my family/shareholders etc. wouldn't be too happy if I got home at the end of the year and explained that we had perfectly matched our liabilities for the year on a gross of tax basis, but had gone backwards due to tax.

Tax matters hugely. That said, as per my earlier comments, I think the tax rules for global shares are needlessly complex (which is something we all seem to agree on), so let's get on and do something about it.
On 14 June 2013 at 10:03 am Cam said:

You said "...via actively managed funds because that is what best practice is overseas".

So in terms of "best practice" funds overseas (UK pension funds?) are you saying they all have a policy of 0% hedging on their international assets?

How much of a home bias should your clients have? Given NZ makes up almost nothing of the world's asset base, is that what you recommend to your clients? So they should have no NZ bonds or shares (and preferably no NZ house) - just unhedged offshore assets? Or if you have a home bias, how do you work out how big it should be (and presumably it is not related to any fx issues)?

I think hedging can have a place because clients think in terms of separate buckets, and generally have pretty short time horizons. Some hedging can help reduce short term volatility in financial portfolios making them happier.
On 14 June 2013 at 11:21 am brent sheather said:
Our clients are virtually all retired and want to live off their income whilst preserving the real value of their property/shares and the nominal value of their bond portfolios so...we are constrained by income as to where we invest..imputation credits give us and any other rational investor a huge reason to overweight NZ..aside from the standard home bias...but you are right..we don't copy NZ pension funds NZ/Australia/international mix for those reasons...with 650m and 2 advisers it has worked out ok.

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