Brent Sheather: Tax system dire for international investing

Two weeks ago we looked at comments by Mark Weldon of the NZX and Carmel Fisher of Fisher Funds that free cashflow and dividends were important variables in assessing the value of an investment.

We noted that dividends can be sourced from two areas, but traditionally they are the difference between what a company sells its product for and what they cost to produce.

With managed funds, the situation is similar. Dividends are usually the result of the difference between what the fund gets in income from its investments less what it costs to run the fund.

We also noted that cashflow and dividend data by itself were meaningless and the information needed to be calculated on a per share basis to be useful for investment decision-making.

Unfortunately the fact sheets from the listed Smartshares Exchange Traded Funds did not provide any of this data on a per share basis and shareholders are simply left to make their own calculations.

This is in sharp contrast with best practice in Britain and Australia, where managed funds with low fees take a great deal of effort to highlight the income produced for shareholders and that income has kept up with inflation or beaten it over the long term.

This week we will compare income, fees and dividends from the low-fee Smartshare Midcap Exchange Traded Fund and the Kingfish Fund, and we will also look at how former Labour Finance Minister Michael Cullen's fair dividend rate of tax affects the cash available for dividends for New Zealanders investing overseas, beyond Australia.

The table, right, compares the operating income, expenses and cash available for shareholders for the NZX listed Midcap Index Fund and the Kingfish Fund in the six months ended September 2010. What it highlights is the impact of annual fees on income for shareholders.

The Kingfish Fund received cash dividends and interest income of $1.2 million in the half-year. However, fees amounted to $1 million and tax took a further $150,000, leaving cash available for shareholders of just $50,000.

There were 86.9 million Kingfish shares on issue, so cash available to pay a dividend to shareholders from operating income was less than one-tenth of one cent per share. This data is for the half-year, but doubling the figure to give the number for the full year probably wouldn't buy you a good bottle of wine unless you owned a couple of hundred thousand shares.

One good point is that this key information was set out for shareholders on one page. There was no historic data provided but, even so, KFL's effort is light-years ahead of what the Midcap report discloses, despite Midcap perhaps having a better story to tell.

The latter's report showed dividend income was $890,000, less fees of $141,000, leaving $749,000 for shareholders. Unfortunately no data per share was provided and, needless to say, there was no historical record.

The Midcap fund has about 16.8 million shares on issue so earnings per share available for dividends was about 4.5c per share. Doubling this number for a full year and with a share price of $2.23 gives a tax-paid yield of 4 per cent. If shareholders are paying 30c in the dollar tax, this is equal to an interest rate of 5.7 per cent - better than the bank.

This 5.7 per cent compares with zero for KFL shareholders on the same basis. But as we noted last time, KFL shareholders are getting about 2.1c per share in dividends each quarter, tax-free, despite the company making virtually no operating profit.

The former chairman of KFL noted enthusiastically in the interim report that "based on the current share price the annual dividend yield of approximately 9.6 per cent is one of the most attractive on the NZX".

The last time I read this sort of nonsense about dividends was, if I remember rightly, back in 1987 when the chairman of Pacer Corporation made the ridiculous statement that his company paid the highest dividend on the stockmarket.

As always, pride comes before a fall, and that company shortly thereafter ceased paying a dividend and then vanished completely.

Carmel Fisher has put together a great portfolio for shareholders of KFL, which has performed admirably despite its fee structure. But it needs to get realistic about its dividend policy. KFL's elevated dividend is unlikely to be sustainable, in light of the poor state of its profit and loss account.

The KFL dividend is being funded from capital - shareholders are simply getting the company's capital returned to them. Take this strategy to its extreme and the dividend could be increased to more than 100 per cent by paying out all capital. But after that the party would be over.

KFL shareholders are in effect dependent on the stockmarket going up to pay their dividend. This is great when the stockmarket obliges but the stockmarket doesn't go up in a straight line and can even go down for extended periods like five or 10 years, by which time KFL shareholders might be getting desperate.

Furthermore, KFL's dividend is likely to be much more volatile than the MDZ dividend, making historic comparison a waste of time. KFL now has a new chairman so hopefully he will institute a more sustainable dividend strategy in line with best practice in Britain and Australia, which will necessarily mean a reduction in annual and performance fees and a much lower and less volatile dividend.

Having said all that, a concentration on fees does not necessarily guarantee outperformance, and KFL, despite its fees, has outperformed the MDZ fund since its inception.

If you are interested in living off your investments, free cashflow is as important a measure for managed funds as it is for companies because of its relevance to dividend-paying capacity. However, consider the free cashflow position of the typical New Zealand fund investing in the world stockmarket, after fees and Cullen's inappropriately named fair dividend rate of tax.

For a start the dividend yield (cash that shareholders get) from the world stockmarket is minuscule, at about 2.5 per cent. If your portfolio is managed by a shareholder/financial planner you need to subtract from this figure around 1 per cent for monitoring/custodial, another 1 per cent payable to the fund manager, 0.3 per cent for platform fees and 0.5 per cent a year for the cost of brokerage, bid/offer spread, etc, incurred when the fund manager buys/sells stocks in the portfolio.

All up annual costs could easily be 2.8 per cent a year so the free cashflow per share is going to be negative before tax.

This is where Cullen's contribution to a tax-neutral environment kicks in: even though the cashflow from your typical actively managed international share fund is likely to be slightly negative, the tax department will have none of this - it assumes that the after-fee dividend yield is 5 per cent so tax at 30 per cent is 1.65 per cent.

The numbers are in the table at left, assuming a 30 per cent tax rate.

This shows investors in your average diversified international share fund can expect income after tax, before the distribution of capital gain profits, of -1.8 per cent, or -$1800 for every $100,000 invested.

And don't think capital profits are going to rescue this situation as most retirees don't like the idea of using up their capital, and capital profits are excluded from the free cashflow calculations of listed companies by fund managers like Carmel Fisher.

The work of Robert Arnott and Dimson, Marsh and Staunton cited in this column has demonstrated that long-term average growth from shares averages about 1 per cent above inflation or 1 per cent below nominal GDP growth; that is, 4-5 per cent a year. With returns equal to dividends plus growth, on a pre-tax basis the long-term expected return from international shares is 2.5 per cent + 4-5 per cent = 6.5-7.5 per cent.

But for the poor old Kiwi investor the numbers after tax are -1.8 per cent + 4-5 per cent = 2.2-3.2 per cent. Three things jump out from this analysis:

•The dividend yield on international shares is low because payout ratios are low.

•Fees are critical.

• The FDR tax system makes international investing with realistic return assumptions look anything but compelling and it needs to go.

Brent Sheather is an Auckland-based authorised financial adviser and his adviser/disclosure statement is available free on request.