Pictured: David Stein
The importance of efficient implementation of investment strategies, especially tax management, is gradually gaining recognition in the institutional market, with a new paper by Parametric Portfolio Associates widening the brief established earlier this month in a paper by Mercer.
The Mercer paper, as previously reported, split the leakages into “upstream” and “downstream”. Upstream involves getting better performance from the companies or stocks themselves, through persuasion or activism. Downstream involves the more quantifiable leakages of fees and transaction costs.
In the Parametric paper, written jointly by the group CIO, David Stein, and Australian head, Chris Briant, the focus is on downstream. This paper provides more detail on what is being left on the table.
According to Seattle-based Stein, who was in Australia last week, taxes usually represent the largest area of leakage, followed by fees. “We have been focused on tax management for more than 20 years,” he says. “We see a lot of lip service but not a lot of action… We don’t claim to be tax experts. We’re not in the business of setting up trusts, for instance. We’re about the active management of tax.”
But, in an expected low-return environment, the action is gradually building in Australia. This has been helped along by the requirement under MySuper, for such fund default options to focus on returns “after fees, taxes and costs”.
Stein says that Parametric has invested a lot in its technology, including spending a lot of programming time on the details for things such as differences in the Australian tax system and other jurisdictions.
“But there are a lot of similarities between the US and Australian tax systems,” he says. “The most important thing is to be focused on tax all the time, as we are.”
Briant says that Parametric in Australia works with PwC, which will provide sign-off advice when required for clients.
The new paper, “Efficiency Matters”, says the four key components in addressing leakages are:
. trading costs – opportunities to reduce the number of trades (physical and FX) and the rates at which they are done through better coordination and execution
. tax liability – by being focused in this area you can significantly improve post-tax outcomes
. loss of members to SMSFs – members leaving hurt a fund’s scale benefits. Some funds have already done good work with member-directed options and there’s more to consider, and
. fees paid to managers – “we believe you should think hard before you pay active manager fees by considering (after-tax managed) passive and systematic alpha or smart beta strategies in addition to selective use of active managers”.
Systematic alpha involves constructing portfolios in a conscious way to adopt strategies such as tax management and rebalancing between uncorrelated asset classes or sectors in the presence of volatility. Smart beta involves adding different factors, such as stock fundamentals, in the construction of an index, which will usually be non-cap weighted.
On fees, which always represent a contentious issue for funds, Stein says he is a strong believer that active fees are often not justified. “There’s very little evidence that there’s a relationship between the level of fees paid and the manager’s performance,” he says.
He actually joined Parametric in the mid-1990s as an active manager but became heavily involved in looking at ways to manage tax effectively. An engineer by training, he helped with new computer systems to actively manage portfolios from an after-tax perspective.
Stein says that some investors may be willing to pay higher fees for reasons other than performance: “What are those other reasons? It’s difficult to know. Are they being ‘sold’ a level of comfort or trust, or perhaps something else?”
For instance, prior to Parametric Stein worked for a large US corporate fund, which, he says, was willing to hire an external manager and pay higher fees rather than running the money internally, so that it had the ability to more readily fire that manager for underperformance.
“This is an issue for internal managers. When they are your staff, they are your responsibility.”