1. How Much Does Tax Erode Fund Alpha? Zhe Chen b, David R Gallagher b, c, d, Graham Harman a, Geoff Warren b, Lihui Xi a, d a Russell Investments b Centre for International Finance and Regulation c UNSW Business School d CMCRC

2. Introduction Few investors are aware of the extent to which the pre-tax alphas reported by actively managed funds are eroded by incremental taxes relative to passive investments. Our study models returns and tax effects of actively managed Australian equity funds (based on their reported monthly holdings), and compares these to the returns and tax effects of passive benchmarks. Tax erodes two-thirds of the 0.74% pa alpha in Broad Market funds, but only one-fifth of the 1.80% pa alpha in Small Cap funds.

3. Background Most fund performance studies use pre-tax returns, either reported (e.g. Jensen (1968), Carhart (1997), Wermers (2000), Fama and French (2010)), or inferred from periodic holdings (e.g. Pinnuck (2003), Cremers and Petajisto (2009)). While these studies show that some fund managers are indeed skilled, they do not examine whether their outperformance persists after tax. Tax modeling has been examined in theoretical and simulated contexts (e.g. Jeffrey and Arnott (1993), Dickson and Shoven (1993), Arnott, Berkin and Ye (2000, 2001), Dickson et al. (2000) and Longmeier and Wotherspoon (2006)). These studies show that tax can have a significant impact on returns, but do not take into account the impact of fund managers’ investment and trading strategies. A few studies (e.g. Sialm and Zhang (2015)) look at the difference between reported pre- and post-tax returns. Our study also considers: ‒Tax attribution, taking into account income tax, imputation credits and CGT ‒Tax effects across different tax brackets.

4. Data Monthly equity holdings for 207 long-only, active Australian equity funds from July 2000 to December 2010, sourced from Russell Investments. Database does not include derivative positions, cash holdings or cash flows. Fund categories are self-declared, based on size (Broad Market vs. Small Cap) and style (GARP/Growth/Style Neutral/Quant/Value) dimensions. No minimum survival period. Outperformance of new entrants vs. existing funds capped at 4.8 bps per month. Prices, returns, dividends and franking ratios were sourced from SIRCA’s SPPR database. Financial statement data was sourced from Aspect Huntley.

5. Database Composition Investment StyleNumber of FundsAverage Stocks Held Average TNA (A$m) Portfolio TurnoverPortfolio Returns Broad Market Neutral3961508.2658.67%6.96% Broad Market Value4362540.242.47%9.35% Broad Market Growth3941508.8251.87%7.49% Broad Market GARP1846385.9856.52%9.35% Broad Market Quant2075296.8271.89%5.41% Broad Market Undeclared1245275.5453.48%0.34% Small-Cap Neutral1155140.6375.20%10.19% Small-Cap Value1085166.6755.17%13.15% Small-Cap Growth661118.157.31%12.33% Small-Cap GARP359129.9347.90%12.12% Small-Cap Quant2121242.7640.14%14.58% Small-Cap Undeclared466161.6960.93%12.85%

6. Methodology The study simulates returns and tax liabilities (using superannuation tax rates) of funds and their benchmarks (S&P/ASX 300 Accum. Index for Broad Market funds; S&P/ASX Small Ordinaries Accum. Index for Small Cap funds), taking into account: ‒Dividends ‒Capital growth ‒CGT (@ 15% on assets held for 1 year) ‒Income tax (@ 15%) ‒Imputation credits (based on 30% company tax rate). Portfolios were rebalanced back to reported holdings at the end of each month. Trades were assumed to be executed at month-end closing prices. Benchmarks were constructed using historic constituent stocks and weightings.

7. Results: Impact of fund style Broad Market funds outperformed the ASX 300 benchmark by 0.74% pa before tax. However, two-thirds of this alpha was eroded by tax. After-tax alpha was significant and positive only for Value and GARP funds. Small Cap funds outperformed the ASX Small Ords benchmark by 1.80% pa before tax. The proportion of alpha lost to tax was much lower - about one-fifth. With the exception of Growth funds, all Small Cap funds outperformed the benchmark after tax. DividendsCapital Gains Pre-Tax Alpha Income Tax Realised Imputation Capital Gains Tax After-Tax Alpha Tax DragAlpha Erosion Broad Market Neutral-0.36%***0.97%***0.61%***0.07%***-0.11%***-0.44%***0.12%-0.48%***79.80% Broad Market Value0.21%***1.17%***1.37%***-0.04%***0.07%***-0.45%***0.95%***-0.43%***31.00% Broad Market Growth-0.53%***0.89%***0.36%**0.11%***-0.18%***-0.37%***-0.08%-0.44%***121.00% Broad Market GARP-0.68%***2.35%***1.67%***0.13%***-0.20%***-0.58%***1.03%***-0.64%***38.40% Broad Market Quant0.03%**-0.72%***-0.69%***0.01%**-0.08%***-0.51%***-1.27%***-0.58%***- All Broad Market-0.20%***0.95%***0.74%***0.04%***-0.08%***-0.44%***0.26%-0.48%***64.60% Small-Cap Neutral-0.46%***3.68%***3.22%***0.05%***0.10%***-0.27%***3.10%***-0.12%***3.60% Small-Cap Value0.19%***0.86%***1.05%***-0.07%***0.26%***-0.57%***0.67%**-0.38%***35.80% Small-Cap Growth-1.13%***1.24%***0.11%0.19%***-0.12%***-0.64%***-0.45%-0.57%***502.30% Small-Cap GARP0.06%**2.13%***2.19%***-0.07%***0.41%***-0.64%***1.90%***-0.29%***13.40% Small-Cap Quant-0.18%***4.33%***4.15%***0.03%***0.00%-0.80%***3.39%***-0.77%***18.50% All Small-Cap-0.30%***2.09%***1.80%***0.02%***0.15%***-0.54%***1.43%***-0.37%***20.60%

8. Results: Impact of market state

9. CGT was a major source of tax drag during the bull market. In other market conditions, franking credits significantly impacted after-tax returns. Broad Market funds experienced significant tax drag during all periods. Small Cap funds’ returns received a boost from tax during and after the GFC because they earned more franking credits (partly from Large Cap stocks held) and incurred less CGT. DividendsCapital Gains Pre-Tax Alpha Income Tax Imputation Credits Capital Gains Tax After-tax Alpha Tax DragAlpha Erosion Broad Market Funds Initialisation-0.22%***1.84%***1.62%***0.02%***0.09%***-0.20%***1.53%***-0.09%***5.80% Bull-0.37%***1.11%***0.75%***0.07%***-0.09%***-0.88%***-0.15%-0.90%***120.20% Bear-0.12%***-0.05%-0.17%0.04%***-0.14%***-0.08%***-0.35%-0.18%*** Recovery0.03%0.93%***0.96%***0.01%*-0.08%***-0.05%***0.84%***-0.12%***12.80% Small-Cap Funds Initialisation-0.06%***2.88%***2.82%***-0.03%***0.27%***-0.41%***2.65%***-0.17%***6.00% Bull-0.43%***1.63%***1.20%***0.06%*** -1.13%***0.18%-1.02%***85.20% Bear-0.63%***3.13%***2.50%***0.07%***0.17%***0.37%***3.11%***0.60%***-24.20% Recovery0.22%***3.13%***3.35%***-0.08%***0.28%***-0.07%***3.49%***0.14%***-4.20%

10. Results: Impact of turnover High turnover (quintiles 1 and 2) and low turnover (quintiles 4 and 5) Broad Market funds outperformed the ASX 300 benchmark before tax. Medium turnover funds (quintile 3) matched the benchmark. In the case of Broad Market funds, tax eroded > 90% of alpha in high turnover funds, and < 40% of alpha in low turnover funds. High turnover funds incurred more CGT earned fewer franking credits. In the case of Small Cap funds, low turnover funds outperformed high turnover funds before tax, delivering higher dividend yields and franking credits, which reduced tax drag. Mean Turnover DividendsCapital Gains Pre-Tax Alpha Income Tax Imputation Credits Capital Gains Tax After-tax Alpha Tax DragAlpha Erosion Broad Market Funds High Turnover106.90%-0.14%***0.67%***0.53%***0.04%***-0.13%***-0.77%***-0.33%-0.86%***161.70% 265.30%-0.22%***0.71%***0.49%***0.04%***-0.08%***-0.43%***0.03%-0.46%***93.50% 350.10%-0.35%***0.36%**0.01%0.07%***-0.14%***-0.38%***-0.44%**-0.45%***4306.10% 438.70%-0.19%***1.84%***1.65%***0.04%***-0.06%***-0.44%***1.18%***-0.46%***28.20% Low Turnover22.80%-0.03%*0.82%***0.79%***0.00%0.02%***-0.32%***0.49%***-0.30%***37.80% Small-Cap Funds High Turnover86.10%-0.47%***2.36%***1.89%***0.06%***0.07%***-0.53%***1.49%***-0.40%***21.20% 261.00%-0.48%***2.40%***1.91%***0.06%***0.10%***-0.60%***1.47%***-0.44%***23.00% Low Turnover35.30%0.09%***2.32%***2.42%***-0.05%***0.27%***-0.48%***2.15%***-0.27%***11.00%

11. Results: Impact of top individual tax rate For individual investors on the highest marginal tax rate, tax drag increases on returns from all Broad Market and Small Cap funds. While 4 of the 5 Broad Market fund styles outperformed the benchmark before tax, none outperformed after tax. While tax drag on Small Cap funds is significantly magnified, Neutral, GARP and Quant funds still deliver positive alpha after tax. DividendsCapital Gains Pre-Tax Alpha Income Tax Realised Imputation Capital Gains Tax After-tax Alpha Tax Drag Alpha Erosion Broad Market Neutral-0.36%***0.97%***0.61%***0.22%***-0.11%***-1.26%***-0.54%***-1.15%***188.80% Broad Market Value0.21%***1.17%***1.37%***-0.13%***0.07%***-1.24%***0.07%-1.31%***95.40% Broad Market Growth-0.53%***0.89%***0.36%**0.33%***-0.18%***-1.04%***-0.52%***-0.88%***244.60% Broad Market GARP-0.68%***2.35%***1.67%***0.41%***-0.20%***-1.65%***0.24%-1.43%***85.70% Broad Market Quant0.03%**-0.72%***-0.69%***0.02%**-0.08%***-1.48%***-2.23%***-1.54%*** - All Broad Market-0.20%***0.95%***0.74%***0.13%***-0.08%***-1.25%***-0.46%**-1.20%***161.50% Small-Cap Neutral-0.46%***3.68%***3.22%***0.17%***0.10%***-0.94%***2.54%***-0.68%***21.06% Small-Cap Value0.19%***0.86%**1.05%***-0.21%***0.26%***-1.58%***-0.48%-1.53%***145.60% Small-Cap Growth-1.13%***1.24%***0.11%0.59%***-0.12%***-1.81%***-1.23%***-1.34%***1191.60% Small-Cap GARP0.06%**2.13%***2.19%***-0.22%***0.41%***-1.63%***0.75%***-1.44%***65.60% Small-Cap Quant-0.18%***4.33%***4.15%***0.08%***0.00%-2.37%***1.87%***-2.28%***55.00% All Small-Cap-0.30%***2.09%***1.79%***0.07%***0.15%***-1.55%***0.46%-1.33%***74.30%

12. Conclusion Re-balancing by active fund managers generates tax drags that substantially erode alpha. Broad Market funds are more adversely impacted than Small Cap funds. CGT is a significant source of tax drag during bull markets; in other market conditions, franking credits significantly impact after-tax returns. Lower turnover funds outperform higher turnover funds before tax. This is accentuated after tax by a lower tax drag on low turnover funds. Higher individual tax rates significantly erode alpha from all funds, especially Broad Market funds. Superior pre-tax investment returns are not sufficient justification for active fund management. Managers need to generate more than enough alpha to cover fees and tax.

13. 13 Megan Ford Real Index @CIFRMedia How Much Does Tax Erode Fund Alpha? DISCUSSANT