By CJ Cowan, portfolio manager of Quilter’s Cirilium portfolios
Marginal gains is a well-known philosophy in the world of business and sport. Tiny improvements in equipment or processes compound over time to make a noticeable difference and produce an edge that others struggle to beat.
Portfolio management is no different, despite everyone’s tendency to focus on the big calls. Asset allocation, market timing, and tactical shifts tend to dominate the conversation as they are visible and more easily understood by clients, and when they work, the value can be conveyed naturally.
But in reality, these sorts of events can be few and far between, or worse, easy to get wrong. Consistent outcomes are often shaped elsewhere through a series of smaller decisions. These can often be very technical in nature and don’t stand out in isolation but add up for a client over time.
Just as some managers and advisers aim to shave as much off the overall cost of investing as possible, there are ways to work it the other way and ensure above benchmark returns. In a world where passive investing is increasingly the starting point, this can give a portfolio manager a compelling edge.
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One of the more consistent sources of this kind of improvement is tax efficiency. Now the tax efficiency of an investment vehicle is unlikely to set pulses racing, but the way you access an exposure can make a tangible difference to the return you ultimately deliver.
Take exchange traded funds (ETFs), for example. Investors have the choice between physical ETFs or synthetic ETFs. On the face of it, both aim to do the same thing by tracking an index as closely as possible. The divergence sits beneath the surface, in how that return is generated.
A physical ETF holds the underlying stocks. For UK clients, this matters when it comes to income from US holdings, where dividends can be subject to 30% withholding tax. For Irish and most UK-domiciled funds that rate drops to 15%, but that is still a noticeable slice of income that is lost along the way.
A synthetic ETF approaches things differently. Instead of holding the stocks directly, it uses a swap to receive the return of the index. This allows the fund to receive dividends without any tax drag.
The end result is relatively straightforward. A dividend yield of just over 1%, which aligns with current market estimates, translates into roughly 15-20 basis points additional performance from a synthetic ETF compared to a physical structure.
On its own, that might not sound particularly significant. But this is where the nature of marginal gains comes into play.
An extra 0.15% or 0.20% in a single year could go almost unnoticed. Over time, though, it compounds in the same way that lower fees do. It is not dramatic, but it is reliable and importantly is a way of adding value without making a call on market conditions or manager skill.
Looking at an example £10,000 investment, 20 basis points saved over five years means an extra £100, £202 over 10 years or £408 over 20 years. It’s not going to change the course of your retirement, but who wouldn’t want that extra benefit for next to no effort for the client.
For those running passive or blended portfolios, this kind of thinking is becoming more important. As fees compress and the scope for traditional outperformance narrows, attention naturally shifts to areas where outcomes can be improved in more predictable ways. Structure, cost and tax all play a role here.
Synthetic ETFs have come a long way and are much better understood than they once were, but they still require proper scrutiny. Partnering with well-established and trusted brands, therefore, is crucial.
While many used to run a mile at the mere mention of a derivative, more complex structures like this are now increasingly assessed on their merits and the value they can add to a portfolio. In markets like the US, where withholding tax is a persistent feature, the case for synthetic exposure is easier to make.
These decisions rarely make headlines, but with value for the client absolutely paramount, that small gain is hard to ignore.
