A super measure of global equity markets returns

INSIGHT A super measure of global equity markets returns Managers of Australian superannuation (super) funds are under increasing pressure to provide more granular disclosure of fees and costs incurred by beneficiaries, those using the funds to save for their retirement. In turn, this is leading to demands for a more accurate representation of the investment opportunity set. One form of indirect cost borne by super funds is taxation on dividend income, whether received from investment in domestic or foreign equities. Given the growing demand for performance measurement net of costs, index providers can assist super funds and their beneficiaries by providing indices that accurately measure post-tax performance. The FTSE ASFA Australia Index Series, launched in 2009, serves this purpose by recording tax-adjusted equity returns from domestic equities. Now, the new FTSE All-World ex Australia Net Tax (Super) Index provides accurate tax-adjusted equity performance for super funds investing in global equity markets. Regulators push for more granular cost disclosure A requirement for greater transparency on cost disclosure is high on the priority list of securities market regulators. From October 1, 2017, most super funds have had to comply with the Australian Securities and Investments Commission s (ASIC) new Regulatory Guide 97 (RG97) 1. RG97 is addressed at issuers of superannuation products and managed investment products issued to retail clients, who are now required to make disclosure in accordance with enhanced fee disclosure regulations. RG97 provides detailed guidance on the standardised disclosure of fees and costs, including indirect costs (a category which includes transactional and other operational costs), costs relating to interposed vehicles and platform costs, all of which may detract from the returns ultimately received by an investor. The introduction of RG97 mirrors developments in other global markets. In the UK, for example, the Retail Distribution Review (RDR), introduced in 2013, banned the bundling of advisor charges and platform charges into investment funds annual management charges. RDR has helped improve transparency in the UK market for retail investment products: specifically, it has removed a previously hidden incentive for financial advisers to recommend funds with high total expense ratios, that in turn paid them the highest commission (see figure 1). 1 See http://asic.gov.au/regulatory-resources/find-a-document/regulatory-guides/rg-97-disclosingfees-and-costs-in-pdss-and-periodic-statements/ CONTINUED OVER PAGE ftserussell.com MARCH 2018 1

Figure 1: Unbundling of platform and adviser charges under UK s RDR Pre-RDR: "Bundled" Total Expense Ratio (TER) Post-RDR: "Unbundled" Total Expense Ratio (TER) Performance Fee Admin Charges Fund Manager Charge Platform Charge Adviser Charge TER Performance Fee Admin Charges Fund Manager Charge Platform Charge Adviser Charge TER Source: FTSE Russell. Adapted from Dewhurst Torevell Understanding fund charges post-rdr. While the RDR targeted the UK retail investor, the UK s securities market regulator, the Financial Conduct Authority (FCA), has recently been pushing for better and more standardised disclosure of costs and charges for institutional investors. In March 2017 the FCA published a market study 2 into the asset management sector, in which it commented that it had found investors awareness of and focus on charges to be mixed and often poor. Speaking at the Australian Institute of Superannuation Trustees (AIST) annual Superannuation Investment Conference (ASI 2017), held in September 2017, Ged Fitzpatrick, senior executive leader, investment managers and superannuation at ASIC, stressed that while costs are not the only factor that investors should consider when selecting an investment product, the regulator s objective is to ensure that investors make a fair post-cost comparison between competing products. Asset allocation, investment risk and strategy are clearly also very important, as are elements of services. One area we are very interested in is that the focus should move to looking at net returns, and that if you have consistency and accuracy in terms of fee disclosure, then the focus can shift to net returns, Fitzpatrick said. 2 https://www.fca.org.uk/publication/market-studies/ms15-2-3.pdf 2

Measuring index returns for Supers The FTSE All-World ex Australia Net Tax (Super) Index provides accurate tax-adjusted equity performance for superannuation funds investing in global equity markets. One form of indirect cost incurred by super funds is the withholding tax imposed on dividend income, whether received from Australian or foreign equities. Currently, most Australian fund managers are measured against their peer group by asset consultants and research houses on a pre-tax (gross) basis. This not only makes comparisons between fund managers inaccurate (since the comparison fails to take into account the actual, post-tax performance of funds), but also risks distorting the investment decision-making process: for example, some investment decisions may appear attractive on a pre-tax basis but unattractive on a post-tax basis. By convention, equity indices are calculated in price return and total return versions, with the first type of index recording equities capital performance, and the second type of index recording both capital performance and reinvested dividend income. Equity index providers typically calculate (gross) total return and net total return indices, where investor returns will lie somewhere in-between the gross and net versions. For gross, index returns are calculated on the assumption that dividends are received gross of tax (i.e., with no dividend withholding tax deduction). For net, index returns are calculated on the assumption that a deduction for withholding taxes takes place at the maximum rate. For Australian super funds, neither of these options provides an ideal outcome. Equity indices calculated using a zero tax assumption would overstate the returns available from global equity markets, given that super funds do face taxes on their overseas dividend income. However, a standard net total return index would understate the performance opportunities available, because super funds may be able to obtain a more favourable dividend tax treatment than assumed in the index calculation. An accurate representation of global equity markets for Australian super funds would therefore take into account the existence of withholding taxes and the dividend tax rates available to super funds. These rates are set by double taxation treaties, which are negotiated on a bilateral basis between countries worldwide. The country of tax residence of a company may not be the same as the country in which its shares are listed. For example, Prada, a company with tax residence in Italy, lists its ordinary shares in Hong Kong, denominated in Hong Kong dollars. In this case, the dividend tax rate for an Australian super fund owning Prada shares would reflect the double taxation treaty between Australia and Italy (not the treaty between Australia and Hong Kong). FTSE Russell currently calculates investor-specific net-of-tax indices for three investor types: a US Regulated Investment Company (RIC), a UK pension fund and an Australian super fund. Until 2018, FTSE Russell s net-of-tax indices for Australian super funds covered only domestic equities. With the launch of the FTSE All-World ex Australia Net Tax (Super) Index in 2018, FTSE Russell is extending this approach to help super funds benchmark the global equity markets. The FTSE All-World ex Australia Net Tax (Super) Index provides accurate tax-adjusted equity performance for superannuation funds investing in global equity markets. The index is market-capitalisation weighted, representing the performance of large and mid cap companies in Developed and Emerging markets, excluding Australia. The index is comprised of approximately 3,000 securities from 46 countries, and derived from the larger universe of the FTSE Global Equity Index Series (GEIS), which covers 98% of the world s investable market capitalisation. The FTSE All-World ex Australia Net Tax (Super) Index applies tax rates to dividends that are applicable to superannuation funds. FTSE Russell also offers the flexibility to apply currency hedging using different hedging exposures and proxies for capital gains tax to the index calculations. 3

Why withholding tax rates make a difference Withholding tax is a tax deducted at source from income (dividend and interest) paid to shareholders that are not resident in the same country as the remitting company. Withholding tax may be reclaimed in part or in full if a double-taxation treaty exists between the country in which the dividend is paid (the tax residence of the company) and the country in which it is received (the tax residence of the investor). Australia has different tax agreements with different countries around the world to benefit the Australian superannuation industry. To see why the post-tax rate at which dividend income is recorded in the index makes a difference, consider figure 2, which shows the dividend withholding tax rate applicable to super funds investing in the shares of companies that are tax-resident in the USA, Japan, Germany and Canada, as well as the maximum withholding tax rates levied by those four countries. Double taxation treaties explain why the super rate is lower in these four countries than the maximum withholding tax rate. The availability of so-called tax treaty relief is usually subject to conditions. For example, the US tax authorities permit super funds to receive dividend income from US companies with a smaller withholding tax deduction than the maximum (i.e., 15%, rather than 30%), so long as more than 50% of beneficiaries, members or participants of the super fund are persons entitled to the benefits under the treaty (i.e., they are tax resident in Australia). Figure 2: Dividend withholding tax example Country Withholding tax rate applicable to Australian superannuation funds (super rate) Maximum withholding tax rate (maximum rate) USA 15.00% 30.00% Japan 10.00% 15.32% Germany 15.00% 26.38% Canada 15.00% 25.00% Source: FTSE Russell as at 1 January 2017. Achieving a 15%, rather than a 30% dividend tax rate for US companies makes a big difference for investors in the global equity markets and benchmarking their performance via a global equity index: as at end-september 2017 the gross dividend yield on US shares was 1.94% (as represented by the FTSE USA Index). Under a 15% dividend withholding tax rate assumption, the gross yield would fall to 1.64% a year (i.e., 1.94%*0.85). Under a 30% dividend withholding tax rate assumption, the gross yield would fall to 1.36% a year (i.e., 1.94%*0.7). Given that the weight of the US equity market in the FTSE All-World Index was 51.28% at the same date, the extra return leakage incurred by using a 30% dividend withholding tax rate for the US stocks in the benchmark (as opposed to the correct, 15% rate for super funds) would be around 14 basis points a year ([1.64%- 1.36%]*0.5128]). CONTINUED OVER PAGE 4

FTSE All-World ex Australia indexes provides Australian super funds with pre and post tax benchmarks that represent their global equity exposure. The indexes are based on the flagship FTSE All-World Index Series, which aims to capture 90% of the world s investable market capitalisation. More than US$1.2trillion in passive funds track the FTSE Global Equity Index Series of which the FTSE All- World ex Australia Indexes are included. Quantifying the withholding tax effect In figure 3 we quantify the withholding tax effect for Australian super funds by showing the return on the FTSE All-World Index under differing dividend tax treatments. In the table the index return is shown in Australian dollars for five consecutive tax years (ending 30 June) and under the following dividend tax assumptions: Total return (i.e., dividends reinvested with no maximum rate deduction) Price return (i.e., no dividends included in the index return) Net return (i.e., dividends reinvested after maximum rate deduction) Super net return (i.e., dividends reinvested after super rate deduction) The gross dividend return and the extra return achievable by swapping the standard net return index to the super-specific net return index are shown in the bottom part of the table. Using the super-specific index added between 23-29 basis points a year in return. Figure 3: FTSE All-World ex Australia Index (AUD) returns under different dividend tax assumptions 2016/ 2017% 2015/ 2016% 2014/ 2015% 2013/ 2014% 2012/ 2013% Price return 13.18-2.53 22.13 17.02 28.28 Total return (gross) 15.97 0.02 25.08 19.93 31.73 Net return (maximum withholding tax rates) 15.33-0.56 24.42 19.30 31.00 Net return (Super rates) 15.61-0.30 24.71 19.53 31.26 Return difference of super rates compared to maximum tax rates 0.28 0.26 0.29 0.23 0.26 Source: FTSE Russell - total return data in AUD, as at 30 June 2017. Past performance is no guarantee of future results. See disclaimer for important legal disclosures. In figure 4 we provide the return attribution from 2012 to 2017. Over the five financial years to 30 June 2017 a super fund achieving the returns of the FTSE All-World ex Australia Index received 15.13% per annum from the price performance of global equities. Adding gross dividend income would have increased this performance by 2.93% a year (i.e., to 18.06%). Deducting withholding tax at the maximum rate (line V, final column) would have reduced the per annum return to 17.4%. However, using the super rate would have resulted in a smaller reduction in return, to 17.66% per annum. This was equivalent to a difference in return of 26 basis points per annum. In other words, a shift to a super-specific global equity index provided a much more accurate representation of the returns available from the world s equity markets. CONTINUED OVER PAGE 5

Figure 4: FTSE All-World ex Australia Index annualised returns in AUD under different dividend tax assumptions 2012 to 2017 Item FTSE All-World ex Australia Index Based on Super withholding tax rate (Super rate) Based on maximum withholding tax rate (Maximum rate) I Price Return 15.13 15.13 II Gross Income return 2.93 2.93 III Withholding tax 0.40 0.66 IV Total Return (I+II) 18.06 18.06 V Net Return (I+II-III) 17.66 17.40 VI Return difference of super rates compared to maximum tax rates 0.26 Source: FTSE Russell, as at 30 June 2017. Past performance is no guarantee of future results. See disclaimer for important legal disclosures. A super measure of global equity markets returns In an environment of significant and increasing pressure for better disclosure of the fees and costs faced by investors, Australian super funds can benefit by using global equity benchmarks that more accurately reflect the dividend tax rates available under double taxation treaties. By incorporating the actual tax rates faced by super funds, the FTSE All-World ex Australia Net Tax (Super) Index provides a better measure of global equity markets returns. The performance difference over the last five financial years has been 26 basis points per annum compared to the standard net-of-tax total return index. More information on the FTSE All-World ex Australia Net Tax (Super) Index 6

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