Those Leaky Dividends

In the spate of press releases in May and June announcing new European ETFs tracking the benchmark S&P 500 US equity index following the expiry of iShares’ exclusive deal with Standard and Poor’s, only a single word – “net” – hinted at the fact that you’d be losing almost a third of your income as an investor to taxes.

In fact, all the new ETFs (issued by Amundi, Comstage, Credit Suisse, db x-trackers, HSBC, Lyxor and Source), as well as iShares’ existing fund, track a “net total return” version of the US large-cap benchmark which assumes that the 500 companies in the index deduct 30% in US withholding tax from each dividend paid.

This means that the gross yield of around 2% on the S&P 500 falls to around 1.4%, net of tax, for an investor in a Europe-listed ETF. If you’re an active trader this may be of marginal concern, but if you’re buying for a long-term savings account, with a target holding period of a decade or two, the effect of dividend taxation is potentially significant.

After all, it’s easy to underestimate the overall importance of equities’ income. James Montier, former strategist at Société Générale and now part of the asset allocation team at fund manager GMO, argued last year that dividends (starting yield plus any increase in income) account for up to 80% of an investor’s total real return over a five-year period. Ideally, therefore, you’d want to forgo as little of that dividend income stream as possible.

Unfortunately, checking how much of an equity market’s dividend income you’re actually liable to receive if you buy an ETF requires forensic investigation.

In the case of the S&P 500, none of the eight European ETF providers makes it clear that its fund’s benchmark is calculated using an assumption that the actual dividends received (and reinvested) are at a rate of only 70% of the declared (gross) amount and, in some cases, it’s hard to spot that there is any assumed deduction of tax at all in the calculation of the fund’s benchmark.

Taking another example, in the document detailing its index calculation methodology, MSCI explains that its net total return indices are based on dividends received from US companies being taxed at 30%, those from German companies at 26.375%, and those from French companies at 25% (taking three examples from the index’s constituent countries).

The iShares MSCI World ETF (LSE: IWRD) is the largest European fund tracking MSCI’s world index, with over US$3 billion under management. According to the index factsheet, companies from the US, Germany and France – which suffer withholding taxes at a rate of between a quarter and a third of the gross amount – collectively account for nearly 60% of the overall benchmark.

However, the fact that the iShares fund tracks the net total return version of MSCI’s index is not immediately clear from the fund factsheet. Only the actual code for the index given on the factsheet – NDDUWI on Bloomberg – is an indication that dividend taxes are being deducted when the index is calculated.

Similarly, Lyxor’s ETF MSCI World fund factsheet states that it tracks the “MSCI World total return index”, without any mention of the fact that the net version of the index is being used. Again, only the index code hints at the deduction of dividend withholding taxes. Amundi’s and Comstage’s sites mention the net of tax index as their benchmarks on the relevant fund factsheets, which have to be downloaded, but not in their headline fund descriptions. db x-trackers and Source, however, do state upfront in their websites’ MSCI World ETF fund descriptions that they are using the net of tax index version as their benchmark.

None of these ETF providers estimates on its website how much the use of the net, rather than the gross, total return MSCI World benchmark actually costs in terms of dividend income forgone. For a multi-country index such as the MSCI World this is admittedly a variable amount given shifting country and underlying stock weightings, but it’s a figure that could still be estimated.

However, it’s fair to say that “forgone” may be putting things too strongly, for two reasons.

It’s important to remember that, with a few exceptions, you can’t avoid dividend withholding taxes completely when investing overseas. If, for example, you’re a tax-paying UK investor and you were to buy the US-listed SPDR S&P 500 ETF (NYSE Arca: SPY) or the competing iShares S&P 500 index fund (NYSE Arca: IVV), both of which pay out dividend income gross to domestic US investors, you would still face withholding tax, since your broker would deduct 30% from the funds’ quarterly distributions on behalf of the US Internal Revenue Service (IRS).

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