It’s well known the taxman takes a bite out of active investment returns—now somebody has measured how big that bite really is.
When the annualized performance of active large-cap core funds in aggregate was compared against the S&P 500 index, it underperformed by over 1% over a one-year period ending December 31, 2022. But the active funds fell up to 3.5% behind annually over five- and 10-year periods.
That’s the finding of the first ever “SPIVA After-Tax Scorecard” from S&P Dow Jones Indexes.
“Even before taxes are considered, active managers operating in broad U.S. equity categories have found it difficult to match the returns of capitalization-weighted benchmarks like the S&P 500,” wrote the S&P Dow Jones researchers. “Some were able to. But even for an investor who can identify those few managers with market-beating potential, to participate in that outperformance, they must also hope that their eventual performance is not unduly diminished by taxes.
“The results of this scorecard highlight that, at least in broad U.S. equities, and at least over the last 20 years, taxes would have made a considerable impact on the average returns of actively managed funds, and that the task of selecting an active fund that outperformed after tax was almost (if not completely) impossible.”
For over two decades, S&P Dow Jones Indexes has released SPIVA Scorecard reports comparing performance over time and after fees and expenses for passive and active products. This is the first time a scorecard compared the after-tax performance of index funds with actively managed funds across investment categories and time spans.
Proponents of passive index investing say its lower costs counter any advantages active managers bring to the table with security selection and timing.
Because passive indexes change only through periodic rebalancing and reconstitution, index funds tend to trade less than their actively managed peers, sell fewer securities outright, and thus incur lower taxes. Since they involve long-term holdings, index funds also often experience a more predictable pattern of redemptions than active products.
SPIVA’s data bears this out: In an average calendar year, an active equity fund distributes an average of more than 7% of its net asset value to investors in the form of capital gains. Over the 20-year period ended December 31, 2022, the average active fund’s annual capital gains distribution was volatile—swinging from a post-financial crisis low of around 2% in 2009 to a post-pandemic high of nearly 14% in 2021. All of these distributions came with tax consequences.
In the typical presentation of SPIVA reports, active and passive products are compared by their relative underperformance, after fees, to a benchmark like the S&P 500. For the year that ended December 31, 2022, 50.29% of all domestic active equity funds underperformed the benchmark index—but after taxes were taken into consideration, 55.31% underperformed. Similarly, over the same period, 54.3% of large-cap core equity funds underperformed their benchmark on a pre-tax basis, while 68.28% underperformed after taxes—a difference of nearly 14 percentage points.
Over longer periods, the divergence between pretax and after-tax annualized returns widens over three- and five-year periods, then narrows again over 10-, 15- and 20-year periods. For example, over five years, 88% of all domestic active equity funds underperformed their benchmark before taxes, while 95.2% underperformed after taxes. But over a 20-year period, 92.1% underperformed before taxes and 96.9% underperformed after taxes.
Looking again at large-cap active core funds, over five years 84% underperformed before taxes and 97.4% underperformed after taxes, but over 20 years 96.4% underperformed before taxes and 98% underperformed after taxation.
When the researchers turned their methodology on S&P 500 and S&P 1500 index funds, they found that the difference between pretax and after-tax returns over time held steady on an annualized basis at under half of a percentage point across the equity categories studied. For example, annualized over a 10-year period ending December 31, 2022, S&P 1500 funds returned 12.4% before taxes and 12% after taxes. Similarly, S&P 500 funds returned just under 12.6% before taxes and more than 12.1% after taxes.
The percentage-point difference between pre- and after-tax returns for active funds over the same 10-year period was three to five times greater than for the indexes: There was a 2.9 percentage point difference for all domestic funds against the S&P 1500, and there was a 1.5 percentage point difference for large-cap core funds benchmarked to the S&P 500.
The timing of capital gains distributions takes a toll on active investors, according to the report. When the researchers plotted out average capital gains distributions against both the performance of the S&P 500 and a fund’s pretax performance against its benchmark, it also found that some of the highest levels of capital gains distributions occurred in years where a fund was already underperforming before taxes, or when the S&P 500 itself was recording negative or only slightly positive returns.
In other words, the tax bite was often the biggest in the years where a fund—or the domestic equity universe in general—failed to deliver returns to investors.
“Over the past two decades, S&P DJI’s SPIVA Scorecards have shed light on the chances of selecting outperforming funds both before and after fees,” the authors said. “However, in part because individual circumstances differ, data on after-tax returns has been less widely available. The results presented in this new scorecard are a first step toward a more accurate reflection of the experiences of many investors, for whom taxes are an inevitable piece of the puzzle.”