The real-world and what is a big trust fund?
Trustees living in the real world are looking for the best outcome. They at least need to be aware of the tax issues when considering investments, no matter how big or small the fund is.
Ideal world v real world
In an ideal world every trust would have a portfolio of international securities, tailored for its particular needs. In an ideal world trustees would take advantage of the double tax treaty and reclaim 30% withholding tax deducted from the dividends on Finnish shares. In an ideal world a trust would complete a US tax return and reclaim the 39.8% withholding tax levied on Master Limited Partnership dividends.
In the real world most people would pay real money not to complete a full US tax return. In the real world, the cost of filling in the forms and reclaiming the tax must be weighed against the tax being reclaimed. In the real world trustees cannot afford to have separate fund managers for the UK, Europe, the US, Asia and Australasia.
On the other hand there are a real benefits to spreading risks internationally. That is true even when there is a tax penalty, but equally tax inefficiencies cannot be ignored.
FREE monthly newsletter
Wills | Probate | Trusts | Tax | Elderly & Vulnerable Client
- Relevant learning and development opportunities
- News, articles and LawSkills’ services
- Communications which help you find appropriate training in your area
A trust fund might be too small to hold a portfolio of individual shares, but it might still hold an individual Gilt to meet University fees in five years’ time. That would ensure that redemption would take place when the trustees expected to have to meet the cash outflow. If coupon income is taxable a low coupon Gilt might be appropriate, on the other hand if the income of the trust is tax-free a high coupon Gilt might be more appropriate.
Investing in half a dozen corporate bonds, maturing over the three years at University, would probably give a better a better investment return but making small investments in obscure securities adds to costs.
Focusing the portfolio
Small funds can only afford a limited number of investments, on cost grounds, whereas larger funds can afford to have many more holdings. Today tracker funds and Exchange Traded Funds (ETFs) make it possible to manage a portfolio with as much granularity as you want. If you want an internationally diversified portfolio there is a global Tracker ETF which has over 2900 holdings. However, assets are allocated on the basis of market capitalisation and so the majority of the fund is invested in the US. For a small fund looking to add a little bit of international exposure with a single holding, it is a good option.
For larger funds looking to control the international exposure there are regional tracker funds and single country ETFs. If you want to increase your exposure to Mexico or Indonesia, it is possible.
There may be other reasons for focusing the portfolio. If it is felt desirable to increase income one may want to invest in more high-yield stocks, alternatively, if one was looking more for growth one can invest more in smaller companies. Whatever the objective, there is probably an ETF which can do the job.
Thematic investment is also possible. There are ETFs focused particular sectors such as water infrastructure, agriculture, oil or mining. The growth of ETFs makes it possible to manage the overall investment strategy within a portfolio much more precisely. For even greater precision a portfolio of tracker funds might be supplemented with a small portfolio of maybe 20 internationally quoted shares.
The alternative to tracker funds is actively managed funds, managed by a good fund manager. There are disadvantages to investing with a good fund manager, even if you can identify one:
- All fund management styles go out-of-favour, sometimes for quite a long time. This is okay if you can hang on, but most of us are human, and don’t.
- Even the best fund managers grow old and retire
- Even before they retire they may decide to change fund management groups and start managing different funds
One thing all the above, have in common, is that they may cause investors to switch funds. If they do that they will have to sell their existing holdings, making capital gains and generating a capital gains tax liability
Tracker funds depend on their low charges and low portfolio turnover to generate outperformance and so switching funds takes place less frequently as switching is driven by changes in strategy.
The larger a fund is, the closer it can get to having a portfolio of individual securities tailored to its particular needs and its particular tax position. However, cost constraints mean that that is an ideal that even the biggest funds can only approach, but never reach.
Whatever the size of the fund, many of the practical aspects of tax planning are positively mundane. It is equivalent to an individual holding his Gilts and REITs which pay income that is fully taxable in tax-free funds but holding foreign stocks, where withholding tax is deducted, personally, so that they can offset the withholding tax against a personal UK tax liability. UK company dividends in effect come with basic rate tax paid and so they fit somewhere in between.
Tax in context
Tax is not the only driver of investment policy, and in any event, small funds have to invest via collectives and so withholding tax is lost anyway. As funds get larger there is more scope to tailor the investment portfolio to the needs of the trust and as they get larger still, dealing with tax efficiency becomes more of a practical proposition.
However, tax issues still affect the relative attractiveness of different investments and that needs to be taken into account in asset allocation and choice of investment. A high coupon Gilt, held to maturity, which will provide a low but safe return to a tax-free investor may for a tax paying investor in the same stock, provide a negative return and lose money.
The LawSkills Monthly Digest
Subscribe to our comprehensive Monthly Digest for insightful feedback on Wills, Probate, Trusts, Tax and Elderly & Vulnerable client matters
Not complicated to read | Requires no internet searching | Simply an informative pdf emailed to your inbox including practice points & tips
Subscribe now for monthly insightful feedback on key issues.
All for only £120 + VAT per year
(£97.50 for 10+)