Appropriate Asset Allocation is the principal determinant of long term investment returns. We hence inquire about the client’s existing Asset Allocation as a first step in our engagement process.

We are repeatedly surprised by the quantum of money allocated to Assets which have the same underlying risk as Equities but where long term Capital Gains are taxable.  Take 2 examples.

1. Private Equity funds are essentially a play on unlisted mid-cap equities, but with higher illiquidity and promoter governance risks.  They are not a separate Asset class because they offer no risk diversification from variables that affect the performance of listed Equities.
2. Structured products are synthetic instruments whose return can be replicated by a combination of Equity and debt allocation.  Further, if one was to model the payoffs on these products, the tail risk of capital loss is seldom displayed to and hence understood by clients.  There is essentially no risk diversification here from listed equities…rather, the risk may have been increased.

What perplexes us, that as both the above products attract Long Term Capital Gains tax, they need to significantly outperform listed equities to deliver the same post tax returns.  If this was understood, why would any rational investor allocate capital to these products?

“Alternative Investments” make complete sense, even if they have unfavourable tax implications, if they result in “risk diversification”, i.e. their returns have low correlation with returns from listed equities.   Examples of such instruments could be Venture Capital funds, funds invested in distressed debt, overseas equities or REITs.

The reality is that such funds earn distributors much higher commissions.  As they are illiquid, the fund houses earn an assured fee income for longer time periods and hence don’t mind paying a multi-year upfront commission – an arrangement that suits both parties.

The next time you are offered a risk instrument other than vanilla equities, we recommend you ask your Advisor three questions

1. How does this product help diversify portfolio risk?
2. What are the tax implications of these products?
3. What are commissions that fund houses pay on these products?

Globally, the Financial Services industry is undergoing a crisis of trust.  The best way to protect yourself is to educate yourself on basics so you can ask the right questions of your Advisors.