Sunday, April 29, 2007

Accounting for the Effect of Australian Superannuation Taxes on My Rate of Return

The earnings of Australian retirement accounts, known as superannuation accounts, are taxed by the Australian government at 15%. Contributions are also taxed at 15%. This is in contrast to the US approach of either taxing the contributions at the regular income tax rate (e.g. Roth IRA) but not taxing the earnings or not taxing the contributions and deferring the regular income tax on the contributions and earnings till the money is withdrawn (e.g. 401k, 403b, traditional IRA). The superannuation earnings tax is deducted at source from managed funds and the amount is not reported to the account-holder/taxpayer. Up till now I have been using the after tax returns on these accounts in my performance calculations combined with pre-tax returns on all other accounts. The correct way to compare returns to a market index is, however, on a purely pre-tax basis. I've now added back in the superannuation tax paid to each month's returns:

Obviously the result boosts my rate of return and I now almost match the MSCI World Index over 10 years and beat the S&P 500 total return index on all time horizons. The change has the effect of increasing alpha very slightly but boosting beta by about 5 percentage points.

I've been fascinated by the concept of "portable alpha" or "alpha-beta separation". This concept is based on the idea that any mutual or hedge fund can be broken down into a market neutral fund and a market index fund. The former is the "alpha" and the latter the "beta". I did a decomposition of my total returns into the portion attributable to the market (estimated beta*MSCI total return) and the residual or market neutral portion:

The total return index is the product of the market neutral and market related indices. This is natural as current returns multiply the capital built up from past returns.


BackOfficeMonkey said...

Hey Moomin,

I love the idea of portable alpha too, there have actually been a lot of products (funds) that came out offering both the beta & alpha combinations for institutional investors. None so far for retail.

On a related note, what do you usually trade? Directional options?

mOOm said...

I trade stock index futures. Mainly NQ. In my Roth IRA I trade QQQQ options. I also trade stocks like AAPL and GOOG around their earnings annoucements. I do some longer term stock trades with closed end funds and the like and also invest long-term. I use both a quantitative model based on daily high-low-close data and discretionary trade tactically intraday a bit.