There is an overwhelming body of evidence demonstrating that active management is a loser’s game when it comes to both stock and bond investing. The evidence led author Charles Ellis to call active management just that—a loser’s game—because while it’s possible to win, the odds of doing so are so poor that it isn’t prudent to try.
The evidence applies even to investors who don’t pay taxes, such as endowments, and investors in tax-advantaged accounts, such as an IRA or 401(k). The odds of winning become dramatically worse, however, in the presence of taxes because taxes are often the largest expense incurred by taxable investors in actively managed funds.
Here’s what active manager Ted Aronson of AJO Partners (which has about $26 billion in assets under management) had to say on the subject of taxable investing and active management: “None of my clients are taxable. Because, once you introduce taxes … active management probably has an insurmountable hurdle. We have been asked to run taxable money—and declined. The costs of our active strategies are high enough without paying Uncle Sam. Capital gains taxes, when combined with transactions costs and fees, make indexing profoundly advantaged, I am sorry to say.”
While Aronson invests his personal tax-advantaged assets in his own fund (thus following his own advice), he invests taxable assets in index funds. In an interview with Barron’s, he stated: “My wife, three children and I have taxable money in eight of the Vanguard index funds.”
To try and address the tax cost issue, actively managed fund families have created tax-managed versions of their funds. These funds focus on reducing the negative drag that taxes have on after-tax returns. The question is: Do active tax-managed funds produce superior results relative to passively managed funds?
Tax-Managed Funds Study
To answer that question, Dale Domian, Philip Gibson and David Nanigian—authors of the study “Is Your Tax-Managed Fund Manager Hiding in the Closet?”, which appears in the Fall 2015 issue of the Journal of Wealth Management—examined the tax efficiency, performance and expense of domestic equity mutual funds with a stated goal of minimizing the taxes paid by their shareholders.
Their study used the Morningstar database (which includes about 2,000 U.S. equity funds) and the Carhart four-factor (beta, size, value and momentum) model to compare the returns of tax-managed funds with the returns of actively managed funds that were not tax-managed, and index funds and ETFs. The study covered the period 2010 through 2014. Following is a summary of the authors’ main findings:
- Consistent with a large body of academic evidence, on average, more than 95 percent of the variability in the returns of these funds is explained by the four common factors in stock returns.
- When compared with their inherently tax-advantaged passively managed counterparts, tax-managed funds fail to save investors more money on taxes than their incremental expenses. The results were statistically significant at the 1 percent level in four of the five years.
- There was little difference between the expenses of tax-managed funds and those of their actively managed, but not tax-managed, counterparts.
The authors also found that in their efforts to more efficiently manage taxes, tax-managed funds basically became closet indexers. In other words, the R-squared figures of tax-managed funds proved higher. In fact, the mean value of the R-squared figures for the tax-managed funds ranged from 0.95 to 0.99 in each year. This is comparable to the R-squared figures of their passively managed and ETF counterparts.
This indicates there really is not very much security selection effort going on among the tax-managed funds. Yet their expense ratios are much higher, averaging 1.00 to 1.09 percent a year, and are indistinguishable from the expense ratios of their nontax-managed counterparts. In addition, the expense ratios of tax-managed funds are much higher than the expenses of passively managed funds.
Despite charging much higher fees, the tax-managed funds simply follow the index-tracking strategies of lower-cost, passively managed funds. Thus, while in many instances the tax-managed funds did produce lower tax bills than those of the passively managed funds, the savings came out to much less than the difference in operating expenses.
The tax-efficiency argument becomes even less convincing when tax-managed funds are compared with ETFs, which are generally more tax efficient than index mutual funds. For example, while the tax alpha between tax-managed funds and ETFs ranged from a 20-basis-point savings to higher costs of 72 bps, extra costs associated with tax-managed funds ranged from 67 bps to 73 bps.
The authors reach the conclusion that the practical implication is to avoid actively managed, tax-managed funds because they appear to be closet-indexers and fail to offer meaningful tax savings to investors. The authors’ recommendation mirrors that of Ted Aronson—investors seeking to maximize tax efficiency in their equity investments should invest in passively managed funds.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.