Let’s level the playing field and get ordinary investors back into the public market

Johannesburg Stock Exchange

“THE Report of the Committee of Investigation into the Promotion of Equal Competition for Funds in Financial Markets in South Africa” was published in September 1992 and is better known as the Jacobs Committee Report.

The report is as turgid as its title.

It laid the basis for the next 30 years of financial sector reform in South Africa, proposing much of the legislative and regulatory scaffolding on which our savings industry now rests. Importantly, it investigated the “attainment of a level playing field for competing financial intermediaries in the country”.

The committee seemed particularly concerned about equalising the competitive landscape for banks and long-term insurers.

The “pressure for more equitable arrangements has coincided with a trend of rising contractual savings and declining personal savings, marked furthermore by the increasing institutionalisation of savings flows”, the committee reported.

Deep in the report, the committee made the point, when discussing the increase in investment flows into institutional savings, that “the support given by the contractual savings institutions to share prices makes rights issues attractive for the financing of new investment and encourages unquoted companies to seek a listing”.

Well, the respected members of the committee could not have been more wrong.

What has in fact happened in the past 30 years is that the more contractual savings have flowed to the institutions and the bigger they have become, the less likely they are to support rights offers or unquoted companies seeking a listing, particularly if those companies are outside the top 100 companies. Regardless of share prices. For it is in this period that the number of companies listed on South Africa’s markets has declined from 760 to just 330. The question is, why has this happened?

The committee makes very little mention of direct portfolio investment by individual investors, trusts, charities, companies and other non-institutional entities, or that these investors might be crowded out by the large institutions. Perhaps this was their blind spot?

The ongoing flow of investment funds into institutions has led to a situation where just 11 institutions now manage 90% of all funds under management in South Africa. It is largely these institutions that fund the Association of Savings and Investments South Africa, staff all the consultative committees and forums, employ the technical experts, policy specialists and researchers and lobby for their own interests.

Economists call this kind of behaviour “rent-seeking”.

It is the large institutions, both collectively and individually, who lawyered up and lobbied, on the introduction of Capital Gains Tax in 2001, for the relatively generous tax treatment that Collective Investment Schemes (CIS), formerly known as unit trusts, now receive. This was in addition to the tax benefits applicable to contractual savings in funds managed by the long-term insurance arm of the industry.

Consider this: income earned by a CIS is taxed as if it is in an investor’s hands in terms of the “flow through” principle, just as income earned on securities owned directly by an investor are taxed in the investor’s hands. No difference here. However, when it comes to gains from trading securities, the equivalence ends.

Neither short nor long term trading gains are taxed at all in a CIS, except as capital gains in the hands of the investor when they eventually sell their units, possibly many years later.

Contrast this with a personal share portfolio: if the investor trades frequently, gains are taxed as income at the investor’s top marginal tax rate; if the investor trades infrequently, gains are taxed as capital gains in the tax period in which the gains are actually incurred.

These capital gains might be slightly offset by the minuscule personal taxpayer Capital Gains Tax exemption of R40,000 per year. Notably, an exemption that has not been increased in years.

It holds, then, that in the case of two identical actively managed long-term portfolios — with one held in a CIS and one held as a personal stock portfolio — the returns on the CIS portfolio will beat the returns on the personal stock portfolio after taxes, before fees. CISs also get to rebalance their portfolios at will, whereas personal portfolio investors can’t, without incurring tax consequences. So the likelihood of two identical portfolios is extremely unlikely.

Of course, the CIS managers then extract their fees and yet, because of the unequal tax treatment, the returns on the CIS may still be higher than the returns of the personal portfolio. It is the institutions that disproportionately benefit from the favourable tax treatment of CISs.

It is not fair to personal portfolio holders, and it is also bad for the market.

It is bad for the market because the bias to size and liquidity that is inherent in all large funds — and which is specifically designed into all CISs — hurts smaller companies. This means CISs generally only invest in large, liquid counters and the larger the fund gets, the fewer individual counters it can consider for investment.

It is also an outrage that investors in tax-free savings accounts are forced to pay fees to institutional CIS managers as the only available way to use a tax-free savings account to invest in shares. Another incentive meant for individual savers that has somehow been diverted to serve the interests of large institutions.

Investors have been abandoning direct investment in the market for investment in tax-incentivised institutional funds for years, and the public markets have been losing listed companies at a steady clip for years too. These two facts are directly related.

If nothing is done, expect the JSE to eventually be a market for only 100 or so very large liquid companies and financial products like exchange traded notes and exchange traded funds.

It is only now that the policymakers at National Treasury have realised that maybe things have been overdone, and they have started a consultation process to relook at how CISs are taxed.

I’d imagine there is not a tax lawyer or fund consultant worth their salt who has not been retained to fight for the interests of the fund management industry. Their arguments will be very well formulated and couched in what is supposedly best for the consumer.

None will raise the issue that by tax advantaging the CISs and other large funds over direct investors, we are damaging the market as a whole, or that we have set in motion the ultimate demise of South Africa’s public markets by turning them into exclusively institutional markets, or that we are hurting all companies outside the top 100 by size and liquidity.

It is time for another Jacobs Committee, this time to investigate levelling the playing field between institutional investors and direct investors, with the objective that both should at least be taxed on a like basis.

This new Jacobs Committee should also consider recommending tax incentives for direct investors to support new listings and to otherwise participate directly in the market, in part to help undo the damage that 30 years of institutionalising our markets has done to smaller companies seeking access to equity capital and to the overall market.

It is time to consider de-institutionalising our stock exchange and getting the investing public back into the public market.

This article first appeared in the Daily Maverick.