The Unwitting Components in an End-Year Distribution

The start of a new financial year is always an important time for investors in managed investments including managed funds and ETFs – it begins with the payment of the previous year’s end of year distributions. There can be some surprises with these distributions – the possibility that, as well as the income received from the underlying investments of the fund being distributed, there may be the distribution of capital gains.

In the normal course of events, a small distribution of capital gains is not significant. However, if there is a larger distribution of capital gains from a managed investment, this provides three important elements that an investor might need to consider:

• How does a large distribution of capital gains impact the after-tax performance of my investment?
• If an investor wants to spend their investment income and preserve their capital, do they still want to spend all their distribution when a portion comes from capital gains, rather than underlying income?
• Does the fund provide enough information about distributions, and after-tax returns?

The Ingredients of a Distribution

Let’s look at an example of a distribution beyond just investment income.

The core of my investment portfolio is invested in index-style options. For me, they are low cost, diversified, reliable and tax effective. One of my holdings is the Vanguard Australian Shares Index ETF. This investment has had two recent distributions that seem to be larger than expected had the distributions been made up of just the underlying investment income. These larger distributions, combined with the high quality of reporting around distributions and tax on the Vanguard website, make it a interesting place to look at how a distribution from a managed investment can contain both income and capital gains.

Over the past 12 months, the average price for the Vanguard Australian Shares Index ETF has been around $90 per unit. On the Vanguard website for the fund, in the portfolio characteristic section, it identifies an average annual yield of 4.4 per cent from the underlying investments. This would imply income from the investment of around $4 per year ($90 x 4.4%) per ETF share held. In the 12 months to 30 June 2022, the fund made distributions of $6.26, somewhat above the amount expected if distributions were made up solely from the underlying investment income.

The investment information available on the Vanguard website allows further investigation. Not only are historic distributions recorded, the usual standard for managed investments in Australia, so are the components of each distribution, allowing the investor to see that the March and June distributions are both higher than expected and do include the distribution of some capital gains.

How are these realised capital gains generated? When investing in managed investments, underlying investment decisions are made by the investment managers. This may include the buying and selling of assets, both as a strategic decision (selling one investment to buy another in the expectation it will perform better) and sometimes to increase and decrease holdings as money flows into or out of the overall managed investment. Buying and selling assets can realise capital gains, which are then distributed to investors.

Because of these factors, distributions from managed investments sometimes include capital gains as well as the underlying distribution of income earned from the investments held.

A simple benchmarking approach might be the best way to identify when distributions are getting larger than expected and might need some more specific investigation as to the amount of capital gains distributed as well. For example, the current share market yield is around 4 per cent — once distributions get much higher than this from a managed investment it will be worth looking into what makes up the distribution and how much might be from capital gains.

Spend the Distribution or Not?

Here is a problem when you receive a significant capital gain as part of your distribution – if you spend it, you are actually spending capital rather than income, even though the money has come to you as part of a distribution.

Spending the full managed investment distribution might see you spending more of your portfolio than you intend.

The easiest solution to this is to reinvest the portion of the distribution that comes from capital gains. You will likely have a sense of from the size of the distribution whether it is more than the expected underlying investment income, and a more careful reading of the statement from the investment manager should allow you to clearly identify the components that are from income and capital gains.

The Need for After-Tax Reporting

The second challenge for investors, particularly those facing higher tax rates, is that larger distributions of capital gains usually mean a higher tax burden.

Let’s go back to the Vanguard Australian Share EFT. Vanguard provides after-tax returns for their funds. The Vanguard Australian Share ETF returns show that someone on the highest marginal tax rate for the 10 years to the end of July 2022 receives a return of 8 per cent pa after tax, compared to a pre-tax return of 9.35 per cent pa. This is a tax loss of 1.35 per cent pa (to the end of July 2022). In this most recent year, where the distribution seemed to be a little higher, the pre-tax return was -2.24 per cent compared to -4 per cent after tax, suggesting a tax loss of 1.76 per cent, a little higher than average.

This brings us to a challenge for investors when, often, after-tax reporting for managed investments is not readily available. For some people, for example investors with a superannuation fund in pension mode and a zero-per cent tax rate, after-tax returns will not be as important. For the rest of us, the after-tax returns matter more that pre-tax returns because that is what we get to keep!

If you don’t have easy access to after-tax reporting for your managed investments, this is a challenge.

To demonstrate this, I went to one of the larger fund managers in Australia and looked for their Australian share fund. The 10-year return (to the end of June 2022) was 8.45 per cent per annum while distributions had been 8.25 per cent per annum over the same period. This meant fund distributions were more than twice the average market rate for the past decade of around 4 per cent pa. Taxable investors would be very interested to know the impact of these large distributions on their after-tax returns. However, I could not find any after-tax returns.

It is also interesting to consider the impact on someone spending their annual investments distributions of 8 per cent per year thinking they were spending their income while preserving their investment capital; over 10 years the capital value of the investment would have only risen fractionally, meaning that in after-inflation terms their portfolio had fallen in value.

Conclusion

One of the positive elements of being an investor in the Australian market is that Australian shares tend to be significant in portfolios and have a history of paying attractive dividends supported by the tax benefits of franking credits. Managed investment distributions are more complex than simply receiving the underlying income from investments and may include capital gains from trading as well as income. It is worth being aware of this and, if distributions are larger than expected, keeping an eye on what makes up the distribution and the impact on after-tax returns.