Future Focus: Tax alpha is becoming more important than market returns
As valuations temper and market returns become subdued, focus on keeping more of what you earn.
It wasn’t hard to get good returns over the past decade.
Markets were rising and even imperfect portfolios delivered strong outcomes. When returns are high, we don’t focus on minor inefficiencies. A few percentage points lost to tax or fees feel less significant when your portfolio delivers double-digit returns.
Many market commentators believe the good times may be coming to an end with predictions suggesting higher interest rates and lower returns. In an environment like this, every percentage point of returns counts. Minimising tax is a great place to start.
Read more: Property has negative gearing, what do shares have? Here are the most common tax deductions for share investing.
What is tax alpha?
Tax alpha is the additional return generated by structuring investments in a tax-efficient way. This isn’t about avoiding tax, but minimising what is lost. Doing so means that more of your investment returns remain compounding in your portfolio.
Why it matters more in a lower return environment
It takes a little bit of maths to understand why tax alpha is more important in lower return environments.
If an investor earns 10% per annum and loses 2% to tax, the after-tax return is 8%.
If the same investor earns 6% per annum and still loses 2% to tax, the after-tax return is 4%.
Tax lowers returns by 20% in the first scenario. In the second, tax reduces returns by 33%.
Aussie investors may not necessarily think of tax in this way due to percentage-based tax on income. While tax is applied as a percentage, the amount of taxable activity in a portfolio doesn’t always fall in line with market returns. Income distributions, portfolio turnover, and realised gains can remain relatively stable, even as overall returns decline.
This means that in a lower-return environment, tax can consume a larger share of total returns. The drag doesn’t need to increase in absolute terms for its impact to become more significant. The tax impact doesn’t change with market conditions, but its relative importance does.
Tax isn’t the only lever investors can pull to keep more of what they own. In low return environments, you have the control to keep your portfolio on track in several additional ways. This is the key focus in my portfolio through all periods of the market cycle.
Market returns are out of my hands. However, I do have faith over the long-term they will continue to trend upwards and reward me for the risk I take on. What I can control is how much I contribute, ensuring I am paying minimal fees and transaction costs, and limiting the poor behaviour that will impact my return outcomes.
Identifying where tax erodes returns
Sometimes tax bills show up in a single large event, such as capital gains upon sale. However, tax drag also can occur on a recurring basis which is less noticeable. It could be poor asset structuring – holding tax inefficient assets in higher tax environments. It could be capital gains triggered by unnecessary portfolio turnover or missed opportunities to offset gains with losses.
Individually, these decisions may seem minor, but they can compound into a meaningful drag on returns.
Consider patience over turnover
We can start with the simplest example of reducing tax drag through investment strategy. There are two investors with identical portfolios earning 6% per annum before tax.
Investor A trades actively, realises gains annually and pays tax at a 37% marginal tax rate. Investor B holds investments longer, deferring capital gains and benefiting from the 50% CGT discount.
Over time the difference in tax outcomes will be significant. Investor A is consistently realising gains and paying tax. It is often difficult to discern the impact as capital gains are calculated at the end of the tax year and may be paid for through other sources of cash. The total return looks like it has not been impacted. For Investor B, the deferral of tax may allow higher contributions to a portfolio.
Even if the portfolios contain similar assets, the after-tax outcome is different. Tax deferral is a source of return.
James Gruber has written on how this forms a key part of his thinking for his investment strategy and why he doesn’t focus on income-generating assets.
Asset structuring matters
Not all investment returns are taxed equally. Interest income and many distributions are taxed at marginal tax rates. Capital gains are taxed more favourably.
As an example, consider the same portfolio in two places - bonds and high-income generating assets outside of superannuation, and inside of superannuation.
Both portfolios may look identical, but the after-tax outcomes differ meaningfully. For higher-income earners, holding tax-inefficient assets in a high-tax environment can significantly erode returns. Income-generating (and therefore tax generating) assets should be held in more tax favourable environments. There’s no additional risk – just better structuring.
Tax-loss harvesting
Market volatility is uncomfortable as we’ve experienced in the last few months. However, it does create opportunities.
When asset values decline, investors can realise those losses to offset gains elsewhere in their portfolio. This is commonly called tax-loss harvesting. When there’s volatility in the market, you have the opportunity to offset capital gains. You can reduce current tax liabilities, carry forward losses to offset future gains or reinvest in similar assets to maintain market exposure.
This is why having an Investment Policy Statement (IPS) is so important. It allows you to make strategic tax decisions which are governed by your investment strategy, and not your behaviour. You are making sell decisions that benefit your total return. If there are positions in your portfolio that no longer serve you, use this as an opportunity to offset gains from other investments.
Why this matters now
Tax alpha does not rely on better market timing or taking more risk. It is purely focused on keeping more of your gains.
As wealth increases tax complexity increases. You might be investing across multiple structures with varying tax rates – superannuation, individual investment accounts, trusts or companies. Look at your investments on a holistic basis and consider where income-generating assets should sit.
Be mindful of your innate action bias. Constantly selecting new investments, reacting to market volatility and chasing returns feels like the right thing to do. Holding an investment to defer tax can feel unnatural and realising a loss can feel like you are admitting you failed. These non-actions can also pay off in the end.
Minimising your taxes doesn’t feel exciting. But over the long-term these actions can make more of a difference than short-term market returns.
Final thoughts
Here’s a checklist to capture tax alpha.
- Be deliberate about turnover by avoiding unnecessary trading
- Use the CGT discount where possible by holding assets for more than 12 months
- Place tax inefficient assets in tax efficient environments
- Harvest losses thoughtfully by using market volatility to your advantage
- Plan investment withdrawals around changes in income or tax brackets – for example, if you know your income may be lower for the next financial year, wait to realise non-urgent withdrawals.
None of these strategies require you to predict where the market is heading. Keeping more of what you earn is always a good strategy. Focusing on tax alpha and other factors within your control will give you a sense of control in any market environment.
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