Swedroe: Taxes Can Be A Real Drag

April 06, 2016

As the annual S&P Active Versus Passive (SPIVA) scorecard demonstrated, 2015 was another painful year for U.S. actively managed funds. It found that 66.1% of large-cap managers, 56.8% of midcap managers, 72.2% of small-cap managers and 61.9% of real estate investment trust managers underperformed the S&P 500, the S&P MidCap 400, the S&P SmallCap 600 and the S&P U.S. Real Estate Investment Trust index, respectively.

Last year, the average U.S. actively managed mutual fund returned -0.41%, 0.89 percentage points below the 0.48% return earned by the Russell 3000 Index. Unfortunately for taxable investors, through the tax impact of Form 1099 distributions, actively managed funds only added insult to injury.

For investors in the highest tax brackets, the impact from dividends was a tax cost of 0.46%. The impact from capital gains distributions was another 1.70%. That means the after-tax return for such an investor was -2.57%.

While any well-diversified portfolio will likely produce a similar tax cost from dividend distributions, the relatively higher turnover of active funds imposes a much higher tax cost than do lower-cost and passively managed strategies (such as index funds) with their lower turnover. For example, Morningstar estimates that for the 15-year period ending February 2016, the total tax cost of Vanguard’s U.S. Total Stock Market Index Fund (VTSMX) was just 0.41%.

The academic literature provides investors with plenty of evidence demonstrating that for actively managed funds, when it comes to the negative impact of taxes, 2015 wasn’t an unusual year.

Historical Evidence

Morningstar’s Jeffrey Ptak contributed to the literature on the impact of taxes with his recent study comparing the after-tax returns of domestic actively managed funds with the after-tax returns of comparable Vanguard index funds.

The study, which included more than 4,500 funds, covered the 10-year period ending October 2015. The methodology Morningstar uses for determining the after-tax returns follows SEC guidelines, which are based on the following assumptions: The investor sells the holding at the end of the time period and pays capital gains taxes on any appreciation in price; distributions are taxed at the highest prevailing federal tax rate and then reinvested; state and local taxes are excluded; only the capital gains are adjusted for tax-exempt funds, because the income from these funds is nontaxable; and the total return is adjusted for the effects of sales loads. A summary of the results is in the table below:

Note that in not a single case were even 11% of actively managed funds able to outperform their Vanguard index fund benchmark on an after-tax basis. And what’s more, the average underperformance ranged from -0.67% to -1.45% (because of survivorship bias, the true level of underperformance is even worse).

Observe that, in each case, only a small minority of active funds outperformed, and that the margin of outperformance earned by these very few winners was much smaller than the margin of underperformance posted by the much larger number of losers.

In other words, the odds of outperforming were not only poor, but the times when funds did outperform, the margin of outperformance tended to be small (from 0.56% to 0.95%). When funds lost, the margin of underperformance was much greater (from -1.16% to as much as -1.71%).

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