Super funds chasing alpha in their multi-manager equity portfolios need to tread cautiously to manage the impact of real-world implementation costs, according to a new paper from the Australian Catholic Superannuation and Retirement Fund (ACSRF) and Parametric.
The research showed that the more a super fund invests in active management, the greater the impact of taxes and other implementation costs.
The paper explored two ways a super fund could limit tax leakage resulting from an active multi-manager program – by including a passive core to have less of its overall equity portfolio exposed to the tax damage done in the active program and by employing tax management in the core portfolio to help shelter the gains generated by the multi-managers from tax.
“Ironically, a super fund will get the best out of its active managers by reserving some allocation for a tax-managed passive core in the portfolio,” according to the paper’s authors, Chris Drew, investment manager, ACSRF, Mahesh Pritamani, senior researcher, Parametric, and Raewyn Williams, managing director, research, Parametric.
They said the stronger a fund’s sensitivities are to the real-world issues of peer and benchmark risk, investment management fees, taxes and transaction costs, then a higher allocation to a tax-managed passive core becomes the optimal solution.
“A high conviction in the skills of active managers (and the fund’s skill in choosing such managers) can counteract this effect; however, if the fund’s active-management conviction is flagging, there will be more incentive to increase the investment in passive management.
“High conviction in active management creates something of a paradox—unless the fund wants to ignore the impact of taxes (which we do not advocate). It strengthens the case for a tax-managed core allocation to provide some damage control over the tax impact of active management.
“Otherwise, only a resolutely pre-tax-focused fund could see paying away a sizeable portion (in our hypothetical example, more than 40 per cent) of the fund’s excess returns in tax as the optimal solution.”
The authors said that super funds lacking strong conviction in active management might be better suited to finding that “sweet spot” that covers an array of skill levels, but still satisfies its risk and fee constraints.
“Within this sweet spot, super funds have the capacity to maximise the after-tax excess returns over a range of possible skill levels,” they said.
“It is healthy for a superannuation fund to approach scientifically the task of optimising a blend of equity portfolio ingredients, seeking to solve for a specific set of fund objectives and constraints. But it may be unhealthy for a fund to finish there without stepping back to survey the broader sweet spot of equity portfolio combinations available with a little more flexibility.”
