After 25 years of study, Research Affiliates has found that taxes are still the largest drag on investment returns.
Advisors are becoming more tax aware, notes “Is Your Alpha Big Enough to Cover Its Taxes? A Quarter-Century Retrospective,” a recent article by Research Affiliates CEO Rob Arnott, but the internal tax expenses caused by the turnover of active mutual funds still weighs on investor portfolios.
Solutions also abound in the form of ETFs, passive index products and smart beta index products, each of which introduces efficiencies to lower a fund’s tax burden, according to the Newport Beach, Calif.-based firm.
“Management fees, the investment industry’s most visible cost, often get more attention than the less visible and typically larger costs associated with trading and taxes,” wrote Arnott. “Investors and their advisors must be alert to managing both pre-tax and after-tax alpha in order for investors to realize the highest possible return from their taxable portfolios.”
The marginal impact of taxes is vast, even at low rates of turnover, he said. Raising the turnover rate of a portfolio from 0 percent to 10 percent results in a more than 18 percent impact on 20-year performance. When Arnott’s research assumed a starting portfolio value of $100 with 6 percent portfolio price appreciation over a 20-year investment horizon and a 35 percent capital gains tax rate, after-tax wealth at the end of the 20 years falls from $320.70 to $262.70 as annual turnover increases from 0 percent to 10 percent.
If many active managers struggle to overcome the drag of their higher fees, even more fall short of their benchmark when turnover and taxes are taken into account, wrote Arnott. Greater tax burdens are caused by higher gross returns, higher turnover and higher dividend yields.
Some managers implement tax-advantaged or tax-aware investing to defer or negate tax consequences. Arnott noted that tax-advantaged investing is usually more aggressive, having systematic rules to manage tax consequences, while tax-aware investing is less objective and may only capture some of the benefits of tax-advantaged investing.
Tax-advantaged investing involves deferring sales to avoid realizing capital gains, loss harvesting to offset gains, lot selection to minimize realized gains, wash-sale management, holding period management and yield management.
While active, factor, passive and smart beta funds all tend to outperform their benchmark gross of fees and taxes, Arnott’s research found that the tax and fee burdens of active and factor funds destroys their ability to beat their benchmarks. In the period from Jan. 1, 2008, to Dec. 31, 2017, active funds outperformed their benchmarks by an average of 0.7 percent gross of fees, but lost ground to underperform by 0.4 percent net of fees, underperform by 1.5 percent after internal taxes before liquidation, and underperform by 1.9 percent after capital gains taxes post-liquidation.
Smart beta funds, on the other hand, outperformed their indexes from 2008 to 2017 by an average of 1.2 percent gross of fees and 0.6 percent net of fees, but underperformed by 0.1 percent after taxes pre-liquidation, and by 1 percent after taxes post-liquidation.