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.

Passive mutual funds fell 1.3 percent short of their benchmarks on average after taxes post-liquidation between 2008 and 2017. In fact, every category researched by Arnott fell short of its benchmarks after taxes post liquidation, with the average mutual fund and ETF returning 1.8 percent less than its benchmark after taxes and post liquidation.

ETFs are able to offer investors even more of the benefits of tax advantaged investing, said Arnott, partially due to their creation and redemption process. Over the entire 25-year period of Arnott’s study, 53.3 percent of the ETFs made no capital gains distributions whatsoever, but only 4.9 percent of mutual funds avoided capital gains.

From 1993 to 2018, no ETF generated a capital gains tax burden higher than 1 percent, while 40.2 percent of the mutual funds in the study did so.

Consumers are often focused on fees, wrote Arnott, but tax issues typically carry higher costs despite their lower visibility. Advisors, on the other hand, often focus on “pre-tax alpha,” investment returns without taxes taken into consideration, when they should probably prioritize the negative alpha caused by taxes, he wrote.

“Advisors can best serve the needs of their clients when they recognize that the quest for pre-tax alpha goes hand in glove with careful management of the tax consequences of portfolio management decisions,” he wrote..

Research Affiliates analyzed the performance of more than 4,000 funds in the Morningstar database over two periods ending in December: a 25-year period from January 1993 and a 10-year period from January 2008.