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How stamp duty can distort investment decisions.

Most of us are familiar with the irritation of discovering how much tax we have to pay when we book a flight with a low cost airline. The annoyance is temporary though and, in the end, does not impact the decision making process. We know that if we fly on a full service airline we still have to pay it.  The only reason that we know about the tax is that the actual cost of the airline ticket has fallen so much that the tax is now a large component of the total cost.

In the same way the falling costs of money management are now making the tax on investing a much larger, and more visible, component. It is getting harder for the new range of low cost funds to bury it. The gradual erosion of initial commission and the move from a bid offer spread to single pricing now means that any other costs are more obvious. It is for this reason that Vanguard imposes a 0.5% charge to cover stamp duty for investors in its low cost UK funds. That sort of pricing is likely to become more widespread as fund charges come down. However, unlike buying airline tickets the impact of tax is now starting to influence behaviour, something that taxes are not supposed to do.  

In the case of investing the problem lies with stamp duty. It is bad enough having to pay it on houses at an exorbitant rate but the imposition of it on investing is ludicrous. No one is any doubt that the country faces a huge pension crisis as the erosion of defined benefit pension schemes moves the onus of saving for retirement onto the individual and away from the state and the employer.  Added to that is the gradual decrease in mortality rates which is increasing the liability to be funded from a pension.  The scale of this shortfall is vast and can only be solved by individuals making their own savings arrangements through ISAs, SIPPs and other pension schemes.

The investment time scale for pensions stretches over several decades and that will draw many savers to equities. You would think the Government would be keen to encourage savers and move the liability from the Treasure to individuals. But no, the Government takes 0.5% of your already taxed earnings as stamp duty before any money goes into an asset. As an upfront charge on say, a twenty year investment, that is pretty steep. Compound that at whatever growth rate you like and it will come to a substantial figure.

It is easy to see then why many investors are attracted to the concept of investing through ETFs, because they don’t incur stamp duty.  In 2007 secondary trading in ETFs became exempt from stamp duty and this has led to a huge rise in their popularity. It is common now to read or hear someone advocating passive investment through the use of ETFs. Part of that is because of this favourable tax treatment.

However, there are substantial differences between a conventional OEIC and an ETF. Most OEICS are simple, long only collective vehicles where the underling stock is bought and held by the custodian under the watchful eye of the trustee. Stamp duty is incurred buying the stock and becomes part of the total expense ratio (TER), even though it is a one-off cost. Funds that have low TERs, which usually goes with low annual management charge (AMC), have less scope to hide the stamp duty. That is why Vanguard charges it separately.  An ETF that doesn’t have that clearly has some attractions.

However, while ETFs started in the same way as “physical” or “in specie” funds that held stock there has been a trend towards “synthetic” or “swap-based” funds that guarantee to deliver the return of the specified index. Doing this obviously raises the question of who is providing the guarantee and whether that counter-party risk is acceptable. The events of 2008 demonstrated that counter-party risk can be a significant issue.

Dealing in ETFs is akin to dealing in ordinary shares and will probably involve a commission to a broker and there may well be a bid-offer spread in ETFs tracking smaller indices. Contrast that to the removal of initial commission on OEICs and the move to single pricing.

Liquidity issues mean that some ETFs do not fully replicate the index being tracked and that may result in a tracking error and/or a higher TER.  Another factor to consider is the domicile of the ETF is also important as that can affect its tax status, especially in regard to dividends.  Moreover, like investment trusts, ETFs are not covered by the FSCS.

A much trumpeted feature of ETFs over OEICs is that they can be traded at any time of the day when markets are open. In contrast OEICs can only be traded once a day, but does that matter if the investment time scale is going to be several decades? 

This is not to imply that ETFs are bad, but they are not as simple as a plain vanilla OEIC and merit some research as to exactly how each one is constructed. In any event the tax system should not discriminate between collectives and give preference to one type over another. Especially, if like ETFs, they are more complex than the taxed alternative.

Of course, the simple solution to this discrimination would be for the Chancellor of the Exchequer to exempt stocks and share from stamp duty. This would not only level the playing field it would encourage people to save and reduce the long term liabilities of his, and future, Governments.  How good would that be?

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