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Asset prices and blue murder

By Michael Coote

Friday 14th February 2003

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The issue of how tax losses are treated as assets by fund managers for inclusion in calculating a unit price emerged last year when FundSource executive chairman David van Schaardenburg was interviewed about a survey his firm had carried out on the matter (NBR, Oct 11).

FundSource discovered there appeared to be no uniformity on how fund managers worked out to what degree a tax loss should be explicitly valued in a unit price.

Asset magazine (Nov 2001) took up the cudgels on tax loss valuation and predicted a crisis ahead. Its editor, Philip MacAlister, went so far as to envisage headlines such as "Fund managers overinflate asset prices" and "Fund managers mislead their investors."

So far those headlines have not emerged, suggesting the question is a little arcane for most investors. But if more fund managers start writing down the valuations of tax losses in a unit price, and if these are substantial, some screams of blue murder could begin to filter through from the fourth estate.

Tax loss valuation has become a significant concern due to the pervasive effects of the three-year international equities bear market on managed funds. Pure international equity funds got hammered last year and balanced funds, which usually hold a sizeable amount in international equities, took a dent as well.

With 2003 potentially shaping up to be a sorry year for international equities, there could be more to come.

Actively trading fund managers have been clocking up fat tax losses and the question arising is whether those losses should be given a monetary value in a unit price and, if so, by what percentage of the value of the loss.

The governing rule for including tax losses in a fund unit price is the statement of standard accounting practice No 12 (SSAP12). Essentially, it requires tax losses to be virtually certain of recovery within a fairly short period if they are to be included in a unit price. Moreover, the losses should be caused in an identifiable and non-recurring manner and be associated with a long-established income history.

Investors in managed funds should get the material benefit of tax losses anyway, regardless of the inclusion or otherwise in the unit price, provided they stay invested until the fund is in profit again and the losses can be applied to reduce tax payments.

Dispute arises when these losses are given a present value included in the unit price. Purists would say tax losses should not be part of the unit price at all. An opposing argument says they should be, at least to some extent, because inequity can arise when an investor sells out before tax losses are claimed against tax bills.

On this argument, the investor selling out should get some early benefit from losses arising when he was invested.

A number of matters arise out of the tax loss treatment debate of practical concern to investors and their advisers. These people should know what the policy for tax-loss treatment is in their managed funds, or any they intend to invest in, and what proportion of a unit price is actually represented by tax-loss valuation.

If tax loss made up a substantial amount of a unit price, there would be concern in the future of the risk of write-down if the fund's auditors so required.

Another issue is reliability of historical fund performance information. Ideally, investors should compare apples with apples when deciding which fund to choose. In practice, they could be comparing apples with oranges if one fund had historically padded out the unit price with tax losses to a degree greater than its peers.

Arguably, the fairest method of comparison would be historical returns net of fees, taxes and tax-loss valuation. But that information could be almost impossible to procure.

A solution would be to set a maximum percentage amount of the unit price that all fund managers were permitted to book out of tax losses. Mr van Schaardenburg has suggested 3%.

For those buying into funds with international equity components, it would be desirable to purchase funds with no or low amounts of tax losses recorded in the unit price. Such assets would be cheaper per dollar invested than funds which had booked a large amount of tax losses into the unit price. When the markets turned up again, all such funds would get their tax holiday but the discerning investor would have paid little or nothing for the tax break.

What is more, the unit price in a no or low tax-loss inclusive fund would accelerate more quickly as the sharemarkets picked up, whereas prices for high tax-loss inclusive units would be more sluggish, needing to have asset inflation do a catchup with the tax loss premium charged at entry.

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