So you think you’re better off in a money market?
Don’t forget about the tax.
Over the last five years the poor performance of the local stock market has led many investors to consider moving away from equity unit trusts. Many have preferred the perceived security of money market funds, where returns have been higher.
Between 1 July 2014 and 30 June 2019, the money market delivered around 7% per year. According to figures from Morningstar, only four out of the 96 local equity funds with track records that long performed better than that. The average equity fund returned only 3.5% per year over this period.
At face value, it therefore would seem that the money market has obviously been the better place to be invested. Every money market fund in the country outperformed the average equity fund.
Things are not always what they seem
However, investors should be cautious about making simple comparisons when looking at returns from different asset classes. That is because the form of this growth is different, and therefore how it is taxed is different. And that can have a significant impact on returns.
All of the return from a money market fund is in the form of interest. After the initial exemption of R23 800 for anyone under the age of 65 or R34 500 for anyone older, this is fully taxable at normal income tax rates. That could be as high as 45% for those earning more than R1.5 million per year.
Growth in an equity fund, however, comes in two forms. The first is dividends, which are currently taxed at 20% in South Africa. The second is the increase in share prices, which is a capital gain. That attracts no tax until the investment is sold, and even then only 40% of the growth is taxable.
The return from a money market investment can therefore be meaningfully reduced by the much higher level of tax being paid. This is increased even further if an investor sold out of an equity fund to buy into a money market unit trust in the first place. That’s because the initial sale would attract capital gains tax as well.
Here’s the proof
A few examples show how this would play out.
In the first example, someone with an annual income of R2 million sells a R4 million equity fund investment. They have held this investment for some time, and the total gain has been R1.5 million. They then immediately put this into a money market fund, where it earns 7.2% per year.
The below table shows the end result of this investment five years later, after all taxes have been paid, and presuming all interest was reinvested after taxes had been paid.
Compare that to how the money would have grown if it had been left in an equity fund. We have used the returns of an average equity fund growing at 3.5% per year, with a dividend yield of 2%:
(Note: This calculation is based on 3.5% growth every year, which of course is not entirely accurate since stock market returns do not come in a straight line. It is however the simplest way to display a comparison.)
It is striking that despite the ‘face value’ growth in the equity fund being less than half of that of the money market fund, this individual would be more than R60 000 worse off after five years if they had moved their investment.
What if there are fewer zeroes?
One might argue that this is a fairly extreme example, incorporating a large capital gain and taxing income at the highest rate. It also presumes that someone was prescient enough to make this switch at almost exactly the start of the five-year period.
Let us therefore consider a scenario involving a less wealthy investor, who switches after two years of poor returns. They therefore have three years in the money market fund. Their annual income is R400 000 per year, so they are taxed at 31%, and the amount they have to invest is only R500 000. They have accrued R200 000 in capital gains on this money.
In this instance, the impact of tax is much lower, so they would be better off than if they had remained in the equity fund, which is shown below:
However, if, instead of the average equity fund, this investor had been invested in the broad market index tracker with the longest history in South Africa – the Grypon All Share Tracker Fund – which grew at 5.5% per year over this period and with a dividend yield of 3.3%, there would not be much difference:
This shows how what might seem like a simple decision is actually far more complicated than it appears. Simply looking at the difference in return between the different kinds of unit trusts does not tell the full story.
Particularly if an investor has to pay a large capital gains tax amount for moving their money, just recovering that loss can take time and therefore take away from the benefit of compounding gains. In the first example, it took two years just for that individual just to break even again.
Investors should therefore be careful about making any decision to move their money without proper consideration of other factors or without professional guidance. Unless they are fully aware of the consequences, they may find themselves worse off than where they started.