In Common Investment Returns we reviewed a few basic measures of returns.
In Assessing Investment Returns we looked at having to analyze returns within proper context.
Today we will see the need to look within the return itself when evaluating true performance.
This is because all investment returns are not created equal.
Gross versus Net Returns
Gross returns are before expenses, transaction costs, management fees, and taxes are deducted to arrive at net return.
Fund and managed portfolio performance may be reported on either a gross or net basis. The trend is to require reporting on a net basis, but there are often variations between countries.
Make sure you know which is reported in your jurisdiction as well as any costs that might be omitted from the performance calculation. Everyone likes to spin their return figures as positive as legally possible.
Investment Costs to Monitor
Various expenses, transaction charges, and management fees are common in mutual and hedge funds, as well as in managed portfolios. When reviewing funds, you can usually ascertain any additional costs to the fund that negatively affects performance.
Key ratios to review are the Management Expense Ratio (MER) and Total Expense Ratio (TER).
We will discuss these costs when we look at mutual funds as an asset class. They vary significantly between funds and can have a great impact on your portfolio growth.
With stocks and bonds, you do not need to worry about management fees.
Don’t Forget Taxes
Taxes are extremely important when assessing returns. Unfortunately, many investors ignore taxes in their analysis.
Taxes can affect your investment performance in two ways.
First, the investment you own may have taxes deducted at the source. For example, foreign dividends or interest may have taxes withheld by the issuer. In many instances, you may get a foreign tax credit for taxes withheld in another jurisdiction, but not in all cases.
Perhaps you own preferred shares paying out 10% annually. If the dividend withholding tax is 25% and there is no treaty allowing you a foreign tax credit, you only receive an actual return of 7.5%.
Had you factored in the foreign tax effect when selecting the asset initially, it may have made the investment unattractive.
Second, in most countries, taxes are payable on passive investment income or capital gains earned on investments. You need to factor in the tax payments as part of your overall portfolio performance.
If you earn 10% in interest income, your gross return is 10%. But if you must pay 40% of that amount in taxes, your net return falls to 6%.
Different Tax Rates Impact Investment Decisions
Earnings from interest, dividends, and capital gains are often differentiated by governments and taxed at varying rates.
For example, in Canada, interest income is taxed at the highest rate for all investment income.
Capital gains are included in income at only 50% of the gain. This causes the effective tax rate on capital gains to be less than for interest income. Additionally, capital losses may be carried forward or back for a number of years to offset other capital gains.
Dividends from eligible corporations receive dividend tax credits that reduce their effective tax rate. Whereas dividend income from non-eligible corporations do not generate a dividend tax credit.
Whichever form you generate your income stream will have implications for taxes payable and your net returns. This can be incredibly important when analyzing and selecting potential investments.
Perhaps you have two Canadian investment options. One offers an annual interest payment of 15%. The other offers a guaranteed capital gain of 12%. If you only consider the gross returns you should take the interest stream.
But if you factor in that capital gains in Canada are only included in income at 50% of the gain, the numbers change. If you are in a 40% tax bracket, you would have a net return of 9% on the interest. Whereas the capital gain would have a net return of 9.6%. An improvement over the interest only investment.
Also, in many jurisdictions, tax is payable when the income is considered earned, not necessarily when it is physically received. We will see how this works below.
Realized versus Unrealized Returns
Realized returns are those where you have received the cash. You receive a dividend or interest. You sell an investment.
Unrealized returns are those that are only on paper.
This can be a tricky area. In my mind, investment gains are not real until the cash is in my jeans.
Unrealized Gains and the Housing Bubble
I believe that unrealized gains contributed to the housing bubble in many parts of North America. Initially, when someone buys a house they usually take out a mortgage. Banks typically lend between 75-95% of the appraised value.
When house prices were rising many individuals had their homes re-appraised at higher levels than when they bought the house. With this extra equity, people took out home equity loans for a variety of purposes.
As the housing market substantially slumped and values fell, these individuals often found themselves with more home debt than the house was actually worth. Faced with greater debt than value, some just walked away from their homes.
When assessing investment performance, it is fine to consider unrealized returns as well as realized ones. However, make sure that you do not count the proverbial chickens before they hatch.
Until your investment is actually sold and the proceeds are in your bank account, much can happen to the asset value. Often, negatively. Do not spend your gains before you really have them.
More Tax Considerations
A second concern with unrealized returns relates to taxes.
At times, interest or dividend income may be accrued but not paid out by the investment.
For example, a dividend is declared in November and payable as at December 20. You physically receive the dividend distribution on January 15. At December 31, you have yet to receive the dividend, but the income is considered accrued.
In many jurisdictions, the tax authorities treat accrued income the same as if you had actually received it.
If you do not want to pay tax on returns not yet fully realized, be careful with the timing of the payment stream of your asset. In some cases, especially with accrued interest income, the impact from taxes is harsh.
As I often recommend dividend or interest reinvestment plans to aid in generating compound returns, you must be careful here. You will “receive” the income, but as it is immediately rolled back into the investment, there is not associated cash in the bank. However, you are still expected to pay the tax due on the income. Keep this in mind when reinvesting income.
Base versus Local Currency Returns
We looked at the difference between base and local currencies in our review of systematic risk.
Always be careful when dealing in multiple currencies. It is crucial that you compare foreign currency returns to the currency you use in everyday life.
That gives you three common variations between investment return calculations.
We will look at three different examples of mean investment returns in our next entry.
