Indexology^® Blog

This is the first blog in a series on the evolution of Australia’s tax-aware investment management (TAIM) landscape.  

In 1999, a new method of calculating Capital Gains Tax (CGT) was introduced in Australia, with assets acquired after its commencement taxed on the basis of time held and type of taxpayer. Assets held for less than 12 months are subject to CGT on the full gain at the taxpayer’s individual rate of tax.  Assets held for longer than 12 months have CGT applied at a discount of between 0% and 50%, depending on the type of taxpayer.

Prior to 1987, Australian companies were taxed on corporate earnings, and from these after-tax profits, would pay dividends.  Those dividends were then taxed in the hands of recipient shareholders at marginal rates as high as 60%.  The combined effect was a tax rate on dividends that could, in certain cases, exceed 78%.

The introduction of dividend imputation in 1987 removed the double taxation of dividends, with tax-resident Australian companies receiving a ‘franking credit’ for tax paid at prevailing corporate tax rates. Shareholders could then use these credits to offset tax on their dividends.  The imputation system was introduced to ensure that taxpayers in effect only paid ‘top up’ tax on dividends, being the difference between the corporate rate and the shareholder’s higher tax rate.

Under the original dividend imputation system, a shareholder with a lower tax rate than the prevailing corporate rate effectively received no value for the franking credits attached to their dividends. For Australia’s superannuation funds this was highly material.  In 1988, a tax rate of 15% had been introduced on the taxable income (including legislated employer contributions) of these pension vehicles.  Among the nation’s largest institutional investors, super funds could not take advantage of the ‘excess’ franking credits they were receiving.  This situation was remedied in 2000 when the tax laws were amended to allow excess franking credits to be claimed by low rate (and tax exempt) taxpayers.

To learn more about how to weigh your after-tax benefits, visit www.spdji.com/tax-aware.

I recently moderated a global webinar for financial advisors on the topic of S&P DJI research on passive versus active investing.  Presenters on the webinar included Aye Soe, our Head of Global Research & Design, Rick Ferri, Founder and Managing Partner of Portfolio Solutions, and Antoine Lesne, Head of ETF Sales Strategy in EMEA for State Street Global Advisors.  Aye is the author of the U.S.-focused SPIVA® (S&P Indices Versus Active) research.  Rick’s firm is a registered investment advisor (RIA) with over $USD 1.4 billion in assets under management, and the firm uses ETFs (index- tracker funds) and indexed mutual funds for asset allocation.  Antoine described the growing adoption of indexing in Europe and talked about how and why this is happening.  In case you missed it, the webinar replay is available on spdji.com.

Some of the questions we received during the webinar were from audience members who were skeptical of our research.  Other comments and questions showed conviction, including the question, “So alpha is a myth?”  Some advisors we meet with state that part of their value proposition as financial advisors and wealth managers is selecting good managers for their clients.  So our research, combined with  Rick and Antoine’s comments and analysis detailing how hard it has been for managed mutual funds to beat index benchmarks, may be perceived by some as questioning the industry’s business practice.

Critical questions we received asked why we don’t address the reason index funds and ETFs also underperform the benchmark indices.  One would generally expect them to underperform, since index funds have management costs that an index does not. Many of the questions sought to clarify how we address costs in our research and I have asked our panelists to help me cover these answers.  You can read some of those questions and our panelist answers in the next post I write.  We saw the highest degree of conviction from our audience in the 10-year findings from our latest SPIVA report, one example of which I have shown below.  To interpret this Exhibit, using the first line example, we see that 89.52% of active mutual funds with a 10-year track record and following a large cap growth strategy failed to outperform the S&P 500 Growth (the benchmark index for the group) over the same 10-year measurement period.

This webinar attracted a global audience.  Appropriately, Antoine Lesne and Aye Soe both spoke about how our SPIVA results, now calculated for several countries and for Europe, increasingly underpin a global trend towards indexing.  Our research and research from State Street Global Advisors which Antoine shared indicate that active managers have a hard time beating index benchmarks regardless of where in the world they are domiciled.

On May 21, 2015 an article appeared in the Wall Street Journal stating that health insurance providers are seeking hefty rate increases for individual health plans in 2016.  Industry analysts had already expected the cost for individual polices to increase because of two changes made by the Affordable Care Act.

1. The elimination of medical underwriting, meaning that any individual can be covered, regardless of their health status.
2. The expansion of covered benefits, meaning that individual policies will cover more types of services than before.

The S&P Healthcare Claims Indices demonstrate that average claim costs per member have increased under the new requirements.  Exhibit 1 shows the trend in claim costs for the individual policy line of business in comparison with the corresponding employer-based medical plans that were not directly affected by the Affordable Care Act provisions.  Compared with cost increases generally ranging between 0%-4% in 2014 for the employer groups, the cost of claims for individual polices rose over 30%, on average.  If we look closer at the costs incurred under individual policies, we can see that Rx expenses increased over 80% in 2014 and may continue to move higher in 2015.  We can expect that much of this increase in cost will be attributed to higher enrollment from populations with greater health needs.  When this less-healthy population obtains insurance coverage and utilizes healthcare services under its plan, both utilization and overall costs could increase substantially.

In the upcoming months, if the covered population in the Individual market is stable, the average per-member per-month costs could stabilize at a new level, reflecting the changes under the Affordable Care Act.  Based on the change in costs that has already been seen, it is not surprising that health plan providers are seeking increases in rates by an average of 25%-50%, depending on costs increases by state.

Catastrophic weather events are happening now as we are experiencing deadly heat in India, floods in Houston, Oklahoma and Mexico, and the drought in California.  The ENSO (El Niño Southern Oscillation): Recent Evolution, Current Status and Predictions report prepared by the Climate Prediction Center / NCEP of NOAA (National Oceanic and Atmospheric Administration) stated on May 26, 2015 that El Niño conditions are present and there is an approximately 90% chance that El Niño conditions will continue through Northern Hemisphere summer 2015, and a greater than 80% chance it will last through 2015.

In some cases as in California where the El Niño may bring much wanted rain, the elevated ocean temperatures are welcome. However, the consistency in temperature increases hasn’t been enough to shift growing seasons, so is more destructive to crops in general than helpful and may disrupt the global food market.

In a post last year, spikes in agriculture following El Niño periods were shown to be significant. Now the study has been expanded to measure all of the five sectors 12 months performance post the El Niño periods. The result is that the global food market is not the only market that may get disrupted. Notice on average that all sectors have positive returns in the 12 months following the El Niño periods.

What is most interesting is commodity sector returns have increased through time in each of the 12 months following the temperature rise since the El Niño of 1982-1983. This is true for every sector except livestock. On average the annual increase using El Niño periods for agriculture is 2.6%, energy 2.0%, industrial metals 1.8% and precious metals 2.4%.

This El Niño may be just another potential boost with a little more octane than in history that can act as a catalyst for commodities.

One year ago (in May 2014), the majority of the citizens of India voted for NaMo (Mr. Narendra Modi, Prime Minister of India), with hopes for “Aache Din” (days of prosperity) for the common man of India through the eradication of corruption, increased transparency, faster growth, recuperation of black money stashed abroad, and improved infrastructure, among other things. Modi also had the daunting task of putting in place things that were left a mess, inherited from the prior government.

Modi started his duty as Prime Minister even before taking oath by inviting the SAARC (South Asian Association for Regional Cooperation) leaders for his oath taking ceremony.  This sent a strong message to the world that he meant business.  As soon as he took office, Modi initiated a slew of measures to change the image of India, such as starting the “Swacch Bharat Abhiyan” (Clean India Mission) and the “Make in India” campaigns, improving the ease of doing business in India, improving relations with foreign countries, implementing measures to revamp Indian railways, and passing insurance bills and GST bills (passed in a lower house).  Modi has also ensured that top-level corruption will practically disappear.

There are few factors that acted in favor of the NaMo government. One of those was the decrease in oil prices, which helped keep a tab on the country’s current account deficit, therefore helping to decrease inflation. The Reserve Bank of India complemented this by reducing interest rates by 25 bps on two separate occasions.

Amid these occurrences, there are indications that India’s economy is reviving, and experts are saying that soon India’s GDP growth rate will overtake that of China.

For more than a decade, foreign portfolio investors and foreign institutional investors (FPIs and FIIs) have been pouring money into the Indian capital markets, except during the financial crises of 2008 (–FPIs and FIIs were net sellers, selling a total of INR 41,200 crores of equities and debt). Now, India is one of the most preferred destinations for FPIs and FIIs. During the past year, the net investments of FPIs and FIIs added up to more than INR 100,000 crores in equities and INR 170,000 crores in debt. [1]

[1] Source: https://www.cdslindia.com/publications/FIIreports.html

Capital Market Performances over the Past One-Year Period Ending May 15, 2015

The past month (April 15, 2015, to May 15, 2015) has been a bear market; out of 22 trading sessions, 15 ended in the red, eroding investor wealth by more than 5%. India’s bellwether index, the S&P BSE SENSEX, is hovering around a six-month low and closed at 27,324 on May 15, 2015.  The index increased by 16% (including dividends) during the trailing 12-month period before that close.

As of May 15, 2015, the S&P BSE AllCap, a broad benchmark index in India, has outperformed the S&P BSE SENSEX by a margin of 8% (the S&P BSE AllCap yielded 24% during the past one-year period. Among the other size indices, the S&P BSE MidCap and the S&P BSE SmallCap both returned 41%, while the S&P BSE LargeCap returned 18%.

On the sector front, the S&P BSE Healthcare was the best-performing index, returning 59%. Meanwhile, the S&P BSE Energy was the only index with a negative return, down 7% during the same period, primarily due to the fall in oil prices.

Source: www.asiaindex.co.in Data from May 15, 2014, to May 15, 2015. Index performance based on total return. Past performance is no guarantee of future results. Table is provided for illustrative purposes only.

During last couple of months the T20 cricket fever was at its peak, thanks to the Indian Premier League, with AB de Villiers and Chris Gale being the players that stand out most due to its flamboyant batting.  Modi’s “inning” is certainly not a T20 or a one-day cricket match, but rather it is a test that will play out over five years. Modi started his maiden inning well by unveiling his vision for India during his first year; however he needs to build a strong foundation for India’s development before dreaming of reelection in 2019.

Note: The S&P BSE AllCap Series (see Exhibit 1), which includes five size and ten sector indices, was launched on April 16, 2015. Historical index values prior to the launch date are back-tested.