Being concrete about the benefits of tax efficient index investment

In my last post I discussed the methods that a UK individual could use to make investments. There were plenty of different methods, all with their own unique tradeoffs.

In this post I'm going to focus just on the issue of tax efficiency. Let me remind you that I'm definitely not a tax professional and this post just reflects my current understanding of the situation. You probably shouldn't rely on it to be correct, and should seek independent advice before using any of this info.

That being said, what I have done is write a simulation of an unleveraged FTSE 100 investment from 1989 to 2016-11-01, as achieved via four methods:

  1. Index-tracking ETF
  2. Index future
  3. Spread bet
  4. CFD

With a 100,000 GBP initial investment, the most efficient investing method (spread betting) has a final account value of 610,718 GBP: 163k higher than the least efficient investment method (index futures), which had a final value of 447,629 GBP. That's a 36% difference!

CFDs and ETFs came somewhere in the middle: the CFD investor would have had 521,090 GBP at the end, while the ETF holder would have 491,957 GBP — and this is with the generous assumption that the fees charged by the ETF provider are 0%.

Spread bets win for a simple reason: they don't pay any capital gains or income tax at all. With an unleveraged investment, the high financing costs of a spread bet are irrelevant. Note that my model assumes that your spread bet provider pays you the full value of a dividend if you had a long position. It is by means guaranteed that this applies to your provider, but there are few companies out there that do do things this way: I will cover a few in the last part of this post.

Why are index futures so inefficient? The reason is that index future returns are net of the risk free rate. This means that you have to stick your unmargined money in a bank account to earn back the risk free rate, and that means you end up paying income tax — the most onerous of all the taxes. Over the sample period the futures strategy ends up paying 115,309 GBP in income tax alone. The capital gains tax obligations are a relatively modest 19,236 GBP. The trading costs of this option are also relatively high (thanks to the quarterly contract roll), at 2,156 GBP but this is dwarfed by the tax charges.

Note that my backtest period includes a period of rather high interest rates in the UK (rates fluctuated around 10% at the beginning of the period). It's likely that investing in futures is more tax-efficient nowadays than it was historically.

CFDs benefit from being able to treat dividend payments on the underlying as capital gains. The CFD investor would have paid only 49,914 GBP in capital gains tax over the period, and no income tax at all. The fact that this number is roughly half the total tax burden of the index future investor reflects the fact that the higher rate of income tax is about twice the rate of capital gains tax.

Finally, the ETF investor would have paid a mix: 46,314 GBP in income tax, and 16,897 GBP in capital gains. This is a total tax burden not much higher than that paid by the CFD investor, but it differs in that the CFD investor's capital gains liabilities mostly arise towards the end of the test (2013 and later), while the ETF is dribbling dividend income away to the taxman almost every year since inception (actually, 1994 is the first year in which the ETF dividend income exceeds the tax-free threshold).

Naturally, for those who are willing and able to invest all their money within an ISA, all of this discussion is irrelevant — in this case, all dividends and capital gains will be tax free anyway, so you may as well just buy an ETF. Individuals who have hit their ISA contribution cap, or who want to do things that are incompatible with ISAs (e.g. hold futures and options, or use leverage) may however find this information useful.

Note finally that my tests make a number of assumptions:

  • You are a UK higher rate taxpayer
  • Today's tax regime applies across all of history
  • For the index future results: that you can save in an easy-access account offering 0.5% above LIBOR
  • You realize your gains somehow to take full advantage of your annual tax free allowance
  • I couldn't find monthly FTSE 100 index returns anywhere (I know this sounds weird, but I really did try quite hard and they were nowhere to be found) so I backed them out from Quandl's FTSE 100 index future data by assuming an annual dividend yield of 3.83%. At least this should mean that my results aren't affected by shocks to the level of market-expected dividiends.

Spread-Betting Providers

From the above we can see that spread betting can be advantageous. However, this conclusion is sensitive to the amount of dividends that the provider passes on to the better. My computed final account value of 610,718 GBP assumes 100% of dividends are passed on, but if just 90% are passed on then you will have only 552,525 GBP at the end — still good, but not much better than a CFD investment. At 85% retention final value is 525,472 GBP, and if your provider is cheeky enough to retain 80% then final value would be 499,698 GBP — almost as bad as holding an ETF.

I gathered some info from around the web about the charges imposed by various spread-betting providers. For long term investors the relevant bits of info are the financing rate and the fraction of dividends that are passed through to you (for a long position). The below table compares a few providers on these criteria, again assuming an investment into the FTSE 100.

(Note that I expect that you would only pay the financing cost on the value of your position that exceeds your cash deposit, so the financing rate may not be at all important for a totally unleveraged investor.)

Provider Financing Cost Dividend Passthrough
Ayondo 2.5% 100%
CityIndex 2.5% I expect 90% given "net dividends", which matches another source
CMC Markets 3% 100%
CoreSpreads 2.5% 90%
ETX 3% 100% but another (older) source says 90%
GKFX ?? 100%?, see also here
IG 2.5% I expect 90% given "net dividends", but other sources say 85%
InterTrader 2.5% 80%
LCG 2.5% Perhaps 80%
SpreadEx ?? 100%

Without considering any other factors, Ayondo seems like the best deal, with full dividend passthrough and low financing costs.