This article was published on 4 July 2006. Some information may be out of date.

A worrying prediction about the way share funds are run

A section in a submission to the government from Shareholders Association chairman Bruce Sheppard caught my eye.

Referring to proposed changes in the way share funds are taxed, he wrote: “The ability of NZ and Australian funds to trade without having to pay tax may well result in higher trading by institutions, as the active funds strive to differentiate their performance from the index by generating trading gains.

“Should this occur, stock brokers and the NZX will be the winners, as long-term empirical evidence suggests that churning is less effective than a buy and hold strategy.”

Active funds are share funds in which the managers select which shares to buy and sell — as opposed to index funds, which hold the shares in a market index.

Under current law, active funds pay tax on their capital gains — basically because share trading is part of their business. Under the government’s proposed changes, funds that invest in NZ and Australian shares would no longer pay that tax.

The change would make those funds more attractive, putting their investors on the same footing, taxwise, as many people who invest directly in Australasian shares.

That sounds good. But Sheppard is worried — and I share his concern — that the change would encourage active funds to trade more often. And frequent trading usually reduces returns.

In one US study, investors were divided into five groups, depending on how often they traded shares. The group that traded least often had average returns a full 7 per cent higher than those who traded most often.

As Nobel Prize winning economist Paul Samuelson puts it, if you buy low and sell high, “your profits in comparison with buy and hold will be enormous. If you can do it. If. Experience shows that out of a thousand money managers and private investors, only a small faction in fact succeed in buying back in at a lower average price than they have sold out at.”

Another supporter of buying and holding is US share investor Warren Buffett — the world’s second richest man after Microsoft’s Bill Gates. “I never attempt to make money on the stock market,” he says. “I buy on the assumption that they could closes the market the next day and not reopen it for five years.”

Traders’ poorer performance is partly because of transaction costs, such as brokerage. It’s probably also partly because frequent traders tend to buy shares that have done well lately and sell shares that have done badly lately. Often they are too late. Shares that have risen fast frequently fall, and shares that have fallen fast frequently rise.

Surely the big financial institutions know all this?

Maybe. But while the average trader does worse than non-traders, there are always a few who perform particularly well. Perhaps they are superior stock pickers, or perhaps they are lucky — although top performers never attribute their success to luck.

Anyway, it’s standard practice for active fund managers to claim they perform better than the market index. And Sheppard expects that under the new tax regime they would trade more often in an effort to prove that.

If this happens, their fees are likely to rise to cover the higher transaction costs. And given that most funds won’t outdo the index over the long term — especially after fees — investors in those funds are likely to end up worse off than if the funds traded less often.

What the active funds gain from the tax change they might lose from increased trading.

That’s one of the main reasons I prefer index funds. Regardless of the tax law, they don’t trade often, which helps to keep their fees low.

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Mary Holm is a freelance journalist, a director of Financial Services Complaints Ltd (FSCL), a seminar presenter and a bestselling author on personal finance. From 2011 to 2019 she was a founding director of the Financial Markets Authority. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary’s advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it.