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Investors will always look to compare the performance of different products. This will happen no matter how many warnings are given. Some product providers will encourage this, particularly those that have the appearance of having good relative returns. This always occurs, despite numerous studies which show that investment decisions made solely on the basis of performance tend to be poor decisions.

Given that investors will always compare past performance, the goal should be to make sure that the starting point for the returns that are compared is accurate and relevant, and there is an understanding of what is being compared.

The general make up of a return is shown in figure 1. It highlights a number of things:

Return to investor = Net return = gross return – fees – tax

If we are going to compare returns, we should compare the returns that matter and are most relevant. This has to be the return that the investor receives. Also, we should compare it in a way that lets investors understand the reasons for any differences and what might be the differences in the future.

In late 2010, the Ministry of Economic Development (MED) issued a discussion document on KiwiSaver disclosure. It suggested a range of options and asked for feedback. One focus was on disclosing gross-of tax but net-of-some-fees returns. However, when it comes to returns, from an investor’s perspective, the only return that matters is the net-of-tax and net-of-all-fees return. Fees should be all costs no matter how they are calculated and expressed. Costs ultimately reduce returns and therefore any regulation that does not require the deduction of all costs, will allow providers to “game” the system. Costs will be shifted to the areas that do not have to be fully disclosed.

A scheme (Scheme D) with a 10% gross return and 4% fees and tax, is not as good as a scheme (Scheme S) with a 8% gross return and 1% fees and tax. Comparing 10% to 8%, will lead many investors to go with Scheme D. The better option is Scheme S as the 6% net of Scheme D, is not as good as 7% net of Scheme S. Comparing gross returns will often lead to the wrong decisions. It is important to understand differences in tax efficiencies and differences in total fee levels and whether they are sustainable.

There is no question about what return the investor actually receives. They can see it in the dollars they have in their accounts. This is the net return. The gross return is open to manipulate and tells the investor nothing about what is important; tax efficiency, fee levels and investment strategy. Gross returns favour managers and hide the manager’s inefficiencies. Net returns are more relevant to investors. Investors should demand that all returns have to be net, net of everything. Of course the manager will want returns to be gross so that investors are not aware of how much the manager and the industry is being paid.

Therefore, if the focus is on gross returns, it favours the “manager” not the investor. If the focus is on the net return, it is more relevant to the investor than the manager. Clearly, the net return is the better return to look to understand and compare.

When the return of one scheme (Scheme A) is compared to the return of another (Scheme B) over a particular period, and the returns are different e.g. Scheme A is higher, there are a range of possible explanations:

• Scheme A may have a better manager i.e. have more skills
• the markets may have been kind to the style of the manager of Scheme A for that particular period (and probably not the next). The “style” describes the type of decisions the manager makes.
• Scheme A may have adopted a different investment strategy i.e. different mix of cash, bonds, property and shares and this mix was better for that period
• Scheme A may be more tax efficient i.e. paid less tax
• the tax rates of the investor may be different. The rates can be 10.5%, 17.5% or 28%
• the manager of Scheme A may have incurred less brokerage and trading costs, including market buy/sell spreads
• Scheme A may have lower management costs.

Given the range of factors that will affect the returns, an investor really needs to know how relevant each of the factors are to them and how they will affect the future return they will receive to help build their wealth. Understanding the past is only useful, if it helps us understand the future. If the explanation for return differences is fees, it is an advantage that is repeatable. If the explanation is style or strategy, it is advantage that is not necessarily repeatable.

Figure 1:

For a given period, each of the types of assets will provide a market return.

Based on the strategy of the fund, the manager will combine the market returns to give a “benchmark” return, which will be adjusted (up or down) by the manager’s skill to give the fund’s gross return. After taking out what the industry is paid, a gross return net of fees return is obtained.

From this, return tax is deducted i.e. what the tax man takes. What’s left is what the investor receives. The net return is what is important.

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