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Postby Charybdis » Mon Jun 11, 2012 6:26 am
Have you ever wondered what is the difference between net total return, and gross total return? Index providers like MSCI usually use three index types:
Prices indexes don't count dividends, only the price of the stocks.
Gross total return indexes reinvest as much as possible of a company’s dividend distributions. The reinvested amount is equal to the total dividend amount distributed to persons residing in the country of the dividend-paying company1. Gross total return indexes do not, however, include any tax credits.
Net total return indexes reinvest dividends after the deduction of withholding taxes, using (for international indexes) a tax rate applicable to non-resident institutional investors who do not benefit from double taxation treaties.
But those ETFs/index funds who invest in foreign stocks (foreign = relative to the domicile of the fund) usually track the net total return indexes.
Isn't it a fallacy?
1) Bogleheads' goal is to capture the whole market return, after all taxes and expenses. The whole market return is the Gross total return index. So I think ETFs/index funds should compare themselves to gross total return indexes, not to net total return indexes!
2) The net total return index assumes the worst case scenario, when a fund pays the full dividend withholding tax after foreign stocks. But only the dumbest fund with the dumbest manager pays the full dividend withholding tax after foreign stocks.
3) The performance of a fund is depends on the domicile of the fund. For example, Ireland/Luxembourg domiciled funds don't pay the dividend withholding tax after European stocks, but pay the withholding tax after US/emerging market stocks. US domiciled funds on the other hand don't pay the US dividend withholding tax, but pay the tax after European stocks etc.
4) Security lending can increase the income of a fund, and also decrease the amount of dividend withholding tax payable. For example, if a fund lends a dividend paying stock to someone who doesn't pay the dividend withholding tax after that stock, then the fund avoids paying the dividend withholding tax in the end.
5) Tax treaties between countries could be more favorable than the dividend withholding tax level is assumed by the index provider, because the index provider assumes the worst case scenario.
6) The replication method affect the dividend withholding tax payable a great deal. An ETF can use not just full replication, but also optimized replication and swap-based synthetic replication. The optimized replication could avoid those stocks where the amount of dividend withholding tax payable is too high. And the swap-based ETFs just "outsource" the index tracking to a counterparty. How this counterparty manages to track the index is unclear. ETFs don't disclose this, as far as I know. So the counterparty could use other clever methods to avoid the dividend withholding taxes we don't even know about.
I always wondered how can the index funds/ETFs produce so low, even positive tracking error, when tracking an international index. I think it is because they use the wrong index! They should track the gross total return indexes, not the net total return indexes.
Because as an investor, I care about the gross total return indexes. This is the market return.
In short, ETFs pay much lower dividend withholding taxes than the level of taxes assumed by the net total return index provider, therefore net total return indexes are easy to beat.
Isn't it a fallacy that international ETFs/index funds track the net total return indexes? Net total return makes the ETFs/index funds look much better than they really are.
And those studies which examined the diversification benefit of investing in foreign stocks, did they count the foreign dividend withholding taxes? So is it worth diversifying internationally, even after paying all the dividend withholding tax?
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Charybdis Posts: 242Joined: 25 Apr 2010Location: Budapest, Hungary
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Re: Net total return vs. gross total return - a fallacy?
Postby Charybdis » Tue Jun 12, 2012 11:10 am
Does anyone know, how much dividend withholding tax does MSCI assume, when calculating the net total return indexes?
For example, here are the withholding tax levels used by STOXX for their total return indexes: http://www.stoxx.com/indices/taxes.html
Of course, no ETF pays that much withholding tax like the figures in the linked spreadsheet, due to tax treaties and withholding tax optimization via security lending.
That is why you must compare international ETFs to the gross total return indexes, which is actually the market return. The net total return index is not the market return. When investing books talk about long term equity returns, they use the gross total return index, but the international ETFs compare themselves to the net total return indexes.
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Charybdis Posts: 242Joined: 25 Apr 2010Location: Budapest, Hungary
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Re: Net total return vs. gross total return - a fallacy?
Postby HongKonger » Tue Jun 12, 2012 11:30 am
Charybdis wrote:
Of course, no ETF pays that much withholding tax like the figures in the linked spreadsheet, due to tax treaties and withholding tax optimization via security lending.
.
Well I pay 30% witholding on all dividends paid by US originated ETFs because there is no tax treaty ... and I know that in HK its the same for several individual stocks such as Prada (Italy) which IPO'd here a year or so ago. Not everywhere has tax treaties!HongKonger Posts: 664Joined: 21 Jun 2011Location: Deep in the Balkans
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Re: Net total return vs. gross total return - a fallacy?
Postby Charybdis » Tue Jun 12, 2012 11:41 am
HongKonger wrote:
Charybdis wrote:
Of course, no ETF pays that much withholding tax like the figures in the linked spreadsheet, due to tax treaties and withholding tax optimization via security lending.
.
Well I pay 30% witholding on all dividends paid by US originated ETFs because there is no tax treaty ... and I know that in HK its the same for several individual stocks such as Prada (Italy) which IPO'd here a year or so ago. Not everywhere has tax treaties!
It doesn't matter how much do you pay as an individual.
I am talking about the internal rate of return of the ETFs. ETFs are domiciled in those countries where the tax environment is the most investor friendly. US ETFs of course don't pay the 30% US withholding tax, which is assumed by the index provider when calculating the net total return. For example, a US ETF could track the MSCI ACWI net total return index. MSCI assumes that this ETF will pay 30% US withholding tax, which is of course not the case. So it is easy to produce so low, or even positive tracking error, when an ETF tracks the net total return index, instead of the gross total return index.
And the European ETFs are domiciled in either Ireland or Luxembourg. Surprise, these countries don't pay that much dividend withholding tax like the assumed numbers by index providers. And there is also the security lending which lowers the dividend withholding tax.
BTW why don't you invest in for example db X-trackers accumulating ETFs? They don't pay out dividends (they reinvest the received dividends back into the ETF right away), and they don't pay 30% US withholding tax, only 15% minus security lending.User avatar
Charybdis Posts: 242Joined: 25 Apr 2010Location: Budapest, Hungary
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