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Category:
Investment News /
Investments /
SP²
/ July 2006
Choose tax efficient investments to up your returns
Yields
on fixed income investments are at historically low levels despite
the recent 50 basis points hike in interest rates. Conservative
investors can, however, enhance their after-tax returns without
undue exposure to the risk of further interest rate increases, says
Tamas Kulcsar from SP² Advisory Services.
“In
a low interest rate environment, cash returns are unattractive and
yield-enhancing investments such as income funds are vulnerable to
interest rate hikes,” says Kulcsar. “Interest rate increases, which
are positive for an income stream, would, however, reduce the
capital value of an investment.”
Furthermore, he says, cash looks “particularly poor after income tax
is taken into account.”
“The average money market fund last year yielded just 4.1% for
investors in the top income tax bracket. This is likely to be
insufficient for most investors’ income needs.”
Traditional solutions to this conundrum include investing in
preference shares or stocks with a high dividend yield, both
offering non-taxable dividend income. However, due to the
inherently higher risk of share investments, and the current yield
of the All Share index at a low 3%, shares would not be a suitable
option for risk averse, conservative investors.
“There are other options are available to conservative investors in
which they can create a tax efficient portfolio with a high level of
income, low volatility and a low correlation to equity markets,”
says Kulcsar. “These options include tax efficient unit trusts,
which can give an additional 2% yield with no increase in
volatility.”
By
combining low risk absolute return unit trusts, dividend-income
funds and flexible fixed interest funds one can construct a
portfolio that meets the above criteria, he noted. The absolute
return funds – specifically the Investec Absolute Balanced, Nedbank
Inflation Beater, Allan Gray Optimal and RMB Absolute Focus funds –
use differing strategies to generate total returns (income plus
capital growth) that exceed an inflation benchmark.
“These funds extensively use derivative instruments – stock market
options and futures – to generate low volatility returns,
predominantly in the form of dividends and capital gains,” says
Kulcsar.
The
dividend-income funds – offered by Absa, Sanlam, Stanlib and
Prudential – use special purpose vehicles to “convert” interest
payments into dividend-based distributions. Dividends are currently
not taxable and capital gains are taxed at a low effective tax rate
of 10% for natural persons.
According to Kulcsar, returns generated by tax-efficient funds have
historically fallen between those of money market funds and income
funds before tax, with 12-month rolling returns of 7.5% to 10%. The
dividend nature of returns reduces the effective tax rate from a
maximum rate of 40% for money market funds to 14%.
“This equates to a tax saving of approximately R20 000 on an
investment of R1m – or 2% of total returns. This is significant
considering that an average income fund’s returns have been around
10% per annum.”
The
2% tax saving means that an investor with a tax-efficient portfolio
receives an after-tax return of 8% instead of 6%. Furthermore,
returns are generated without significant risk of capital loss.
“Risk – as measured by the annualised standard deviation – is, in
fact, comparable to investing in traditional income funds,” he says.
“The source of the potential risk differs from that of income funds,
as returns depend more on manager skill than market performance.”
“Traditional vehicles for conservative investors, such as money
market and income funds, rarely lose capital,” says Kulcsar. “If
they do, capital loss is minimal and usually due to an unexpected
interest rate shock.”
“To
counter any small, unexpected falls in capital, investors should
view the returns of tax efficient funds over 12-month periods.
Investors should be willing to tolerate potential short term capital
losses, knowing that the probability of achieving a satisfactory
annual return is high, especially on an after-tax basis.”
Source: ITInews – Insurance
Times and Investments Online
www.itinews.co.za
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