In a recent article 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 fi nancial 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.
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 portfolios1) 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
|FUND A RETURN||FUND B REQUIRED RETURN||FUND B EXCESS REQUIRED RETURN|
|6% p.a.||6.25% p.a.||0.25% p.a.|
|8% p.a.||8.42% p.a.||0.42% p.a.|
|10% p.a.||10.60% p.a.||0.60% p.a.|
|12% p.a.||12.81% p.a.||0.81% p.a.|
Source: Investec Asset Management.
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).
1 ASISA Standard on Fund Classifi cation for South African Regulated Collective Investment Scheme Portfolios, 30.10.18.