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.