WHY TAX AFFECTS EQUITY RETURNS

The tax paid* on your overseas equity dividends is not usually top of the pile when talking about your investment strategy.

However, the issue is significant. Long-term returns can vary by up to 0.5% p.a between two identical global equity indices due to the differing treatment of dividends*.

Graph-1-(1).png

  30 years to 31.12.2014
MSCI World Net Dividends Index Gross Dividends Index
Return p.a. 9.1% 9.6%
Excess p.a. 4.9% 5.4%


Source: Bloomberg. Index returns quoted in USD unhedged. Excess return calculated over 3m USD LIBOR


But I thought UK pension funds didn’t pay tax?

This isn’t true for overseas investments. The level of tax depends on two key things:
– The access vehicle (e.g. segregated, pooled life fund, pooled OEIC, unit trust etc.)
– The nature of any double taxation treaties between the country of vehicle domicile and each overseas market in which equities are held

What does this mean?

In practice, the level of withholding tax* on dividends can vary considerably. For example, a pension fund investing in US equities through a UK Life fund will pay no tax on the US dividends. Yet a pension fund investing through an Irish UCITS or Lux SICAV will pay 30% tax (rate sourced from asset managers).

To calculate the difference, we can compare the returns on a global equity life fund with a global equity ETF with the same benchmark.

So what?

The amount of withholding tax payable has significant implications for equity expected returns. It is important for pension funds to understand and respond to this. To help clients, we’ve built a framework which takes this and other significant costs into account when calculating expected equity returns*.

Why isn’t this issue more widely known?

The advent of ETFs tracking indices has forced a more in-depth examination of the returns they experience compared to the benchmarks. In December 2014, the NAPF published a guide to the issue of witholding tax here.

Passive funds and ETFs are invariably benchmarked against "net dividend" indices, regardless of the investment vehicle's ability to reclaim withholding tax. In some cases, this provides an easy benchmark for the manager to outperform, even for passive funds. For example, take a look at the long term returns of the passive Blackrock Life Global equity fund (source: Blackrock & MSCI) – it has a long term performance record relative to the benchmark that many active equity managers would be happy with!

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There is good news…

Most of the major passive and ETF providers (such as Blackrock, VanGuard and LGIM) are raising the profile of the issue. This has driven recent innovation in developing efficient investment vehicles.

But challenges remain….

There is still some variation out there, particularly regarding providers who run funds for pension and non-pension clients.

Conclusion

If your pension fund is invested in equities, check the applicable withholding tax rates. It could have a significant influence on your expected returns.

Note: Redington does not offer tax or legal advice – speak to your tax adviser for further information. We are looking at this solely in terms of the investment characteristics, not the tax characteristics.