Have you seen the videos where people get bitten by dead sharks? They normally involve crazy fishermen putting their hands inside a dead shark's mouth…and before they know it…CHOMP… the hunted [albeit already dead] becomes the hunter. Had these fishermen read page 238 of 'A Field Guide to Coral Reefs', they would have known that touching a not-long dead shark's tooth triggers a reflex response that results in the shark's jaw snapping tightly shut. Given that the force of a shark's bite has been measured to be around 3,000 kg per square centimetre, you can only imagine how messy this could be!
So what's the link to investment management? Well, it's my belief that following the introduction of the Portfolio Investment Entity (PIE) regime, investing your money in direct New Zealand shares as opposed to a PIE managed fund, is similar to sticking your hand in a dead shark's mouth. Yes, it could be kind of interesting, but it's also risky, with little or no real upside.
You may already have heard about 'PIE' from your bank manager or financial adviser. For those unfamiliar with it, the PIE legislation removes the significant tax disincentives that managed funds once had, relative to investing in shares directly. Under the PIE regime, the capital gains and income earned by investments within certain managed funds are being taxed differently and, in most cases, more favourably for investors. For many investors this has now tilted the playing field from a tax perspective in favour of PIE funds - particularly for New Zealand investments like shares and fixed interest assets.
Tax free capital gains on New Zealand shares
If you invest your money in a PIE fund of New Zealand (and certain Australian) shares, you can now be certain that you will not have to pay tax on your capital gains. PIE funds are exempt from paying tax on capital gains and investors only have to pay tax on the dividend income generated by these funds. An investor in a PIE fund additionally benefits from having the tax on their dividend income capped at 30%, but an investor in direct shares would be taxed at their marginal rate. This presents an obvious advantage for investors on marginal tax rates of 39% and 33%.
An added benefit of investing in New Zealand and Australian shares via a PIE fund is that the fund can actively invest and trade the shares in the portfolio without any risk of having to pay capital gains tax. In contrast, individuals investing directly in New Zealand shares do not have the same guarantee that they won't have to pay capital gains tax.
Greater risk of capital gains tax through holding shares directly
So why is investing your money in direct New Zealand shares similar to sticking your hand in a shark's mouth? Well, this comes back to the last point I made. Unfortunately, many investors do not fully understand the rules around whether or not they need to pay tax on their capital gains. Many believe that the Inland Revenue is interested in the level of transactions they make in order to determine whether they are required to pay tax on capital gains.
In fact, the level of transactions is not necessarily relevant. The real test to determine whether an individual is liable for capital gains is around intent. Specifically there are two main instances when the gain on the sale of a share is taxable. The first is if the share is acquired with the intention of making a gain. The second is when the investor is in the business of buying and selling such assets.
So can one categorically claim that an individual who holds shares directly won't ever get clobbered for tax on capital gains? Well, not really. As part of my research into this article, I was surprised at how many investors kept detailed records of the reasons (other than making a profit of course!) about why they had bought or sold shares. If they did not believe there was a risk of paying capital gains tax, why would they go to the trouble of taking the extra precaution to prove they are not a 'trader'? Surely an individual could unwittingly create a trail of documents and evidence that might lead the Inland Revenue to determine their intent was in fact to make a gain.
So why, in the world of PIE, where there is now a tax incentive for many to invest in PIE funds, would an investor take an additional risk and invest in New Zealand shares directly?
The fee myth debunked
Most advocates for direct shares use the argument that the fees charged by managed funds make direct investing in New Zealand shares a far more attractive proposition. However, I would like to highlight this is offset by the uplift in the net return as a result of the PIE tax benefits. Let's use an example to illustrate this point.
Assume an investor has a marginal tax rate of 39% and the dividend yield of the New Zealand share market averages 6% per annum. Because PIE tax is capped at 30%, the net return that an investor receives is approximately 0.54% per annum greater on a net of tax basis through a PIE fund than if they held New Zealand shares directly. This is effectively like increasing the gross return to the investor by approximately 0.9% per annum.
But that's not all. Since a PIE managed fund can actively invest and trade in shares without any risk of having to pay tax on capital gains, there is an increased likelihood of generating outperformance. This is particularly true if you, like me, believe that investment markets are inefficient. A managed fund is run by a team of investment specialists focused on exploiting these inefficiencies, with the aim of generating better returns than the market. And, because an investor's money is pooled together with that of others, they benefit from a true diversification of risk as well as access to rare opportunities that individual investors might otherwise have been unable to achieve.
Together, these factors largely offset the fees required for accessing managed funds. It should also be remembered that investing directly in shares is not without its own costs and fees. So, in conclusion, I do not believe the fee argument has much weight to it. I think the only legitimate reason for investors on marginal tax rates of 39% and 33% to invest directly in shares, is if they have a deep conviction that this approach will generate a materially better return than investing in a professionally managed PIE fund. However, this conviction might potentially land them in hot water with the Inland Revenue.
Why take the risk?
Now I want to be clear. I don't think that it is likely that an individual will have to pay capital gains tax on their portfolio of directly held NZ shares. The thing I question is why, in today's PIE world, would anyone take the risk? PIE funds provide certainty that capital gains will not be taxed, coupled with the tax savings that are available to those investors on marginal tax rates of 33% and 39%. They also provide investors with a 'simpler' investment option - saving them the time and additional costs associated with investing directly, while allowing them to take advantage of the extra research capabilities and skills of professional investors and the additional diversification benefits that managed fund investing can bring.
Even if I have not convinced you of the benefits of managed funds and PIEs for enhancing returns, then I would get you to think once more about the risks that are associated with investing directly in New Zealand shares. It could, potentially, be no different from sticking your own hand in a dead shark's mouth.
All managed funds available through RaboPlus are Portfolio Investment Entities (PIEs).