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Index Funds Keep Their Tax Break

By Mary Holm

Monday 18th December 2000

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Lucky index fund investors have got an early Christmas present. Inland Revenue recently announced - after a review that made some in the industry a bit nervous - that index funds can keep their tax advantage, provided they behave themselves.

Index funds hold the shares in a share market index, such as the NZSE40. The funds have become popular in New Zealand since the first one, TeNZ, was launched in May 1996.

We now have about a dozen, including the country's biggest share fund, AMP's WiNZ, which invests in the shares in a worldwide index.

I've liked index funds since I first heard about them in America in the 1970s. They have several advantages over other share funds, which are sometimes called active funds because their managers actively choose which shares to buy and sell.

Active funds must pay their managers high salaries. Index funds, which trade only when the index changes, need no such expertise. Also, with less frequent trading, index funds pay less in brokerage.

All of this adds up to lower ongoing fees - often about half of what's charged on similar active funds. That can really affect returns over the years.

Another advantage for New Zealand index funds is that they have binding IRD rulings saying they don't have to pay tax on capital gains when they sell shares. Active funds, on the other hand, do pay that tax. This, too, has a big impact on returns.

With several of the index funds' binding rulings expiring soon, Inland Revenue decided earlier this month it would renew them, provided the fund managers meet a list of criteria.

"The most significant is that trustees or fund managers must adhere to strict tracking of the benchmark index at rebalancing dates," says John Mora of the IRD.

The rulings will be issued for three years only, and the IRD will closely monitor court decisions and legislative developments in the meantime.

The decision must have been disappointing to managers of active funds. Still, many will continue to maintain that, despite their tax disadvantage, their funds are better investments than index funds.

If you invest in an index fund, their argument goes, the fund will perform only as well as the sector of the share market represented by the index.

TeNZ, for instance, is based on the index of New Zealand's biggest ten companies. It performs as well as our large company sector. MidNZ, based on the index of the 11th to 40th biggest companies, performs as well as the middle sector.

Managers of active funds often claim that, by clever share trading, they can perform better than the index of the sector in which they operate.

Often, though, they're not using an appropriate index in their comparison, or they don't adjust properly for risk.

International research has found that, over the long term, only a few active funds deliver higher returns than similar index funds - especially after taxes and after fees. And nobody can tell, in advance, which those few will be.

Sometimes, there aren't any. Consumer magazine recently looked at WiNZ and Tower's TORTIS-OZZY, which invests in the shares in an Australian index.

These funds "have beaten all New Zealand-managed funds in their categories over the last three years," says Consumer.

"WiNZ has turned $100 into $237 over that time, whereas the average for actively managed global unit trusts was $152." Since that was written, WiNZ' performance has dropped a bit. But so have other global funds.

Adds Consumer, "TORTIS-OZZY's return has been twice that of some New Zealand-based unit trusts investing in Australian shares."

It's unusual for index funds to do quite that well. But, over the long haul, they tend to be excellent investments.

Mary Holm, a freelance journalist and author of "Investing Made Simple", is commissioned by the New Zealand Stock Exchange to write an independent personal investment column. She can be reached by E-mail at maryh@journalist.com or by mail care of this newspaper. Sorry, but she cannot respond directly to readers.

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