Odds Of Outperformance
Using the large blend category as an example, we can calculate the risk-adjusted odds of outperformance. With the 95.2% of active funds that underperformed managing to do so by an average of -1.17%, and with the 4.8% of active funds that outperformed doing so by an average of 0.76%, the risk-adjusted odds of outperformance were 31:1!
The risk-adjusted odds of outperformance for the other categories are: large growth: 18:1; large value: 13:1; mid blend: 61:1; small blend: 46:1; small growth: 23:1; and small value: 13:1. The average risk-adjusted odds of outperformance when equal-weighting all seven categories were 29:1. Again, keep in mind that because of survivorship bias, the risk-adjusted odds of outperformance are actually worse than these already-abysmal figures suggest.
As you consider this data, it’s important to understand that because of the two major bear markets we experienced in the first decade of this century, the impact of taxes on returns over the period that Ptak examined is likely to have been less than the long-term experience. As a result, it’s important to look at data from prior periods. With that in mind, we will now look at the research from prior periods.
Taxes Can Eat Alpha
In their 1993 study, “Is Your Alpha Big Enough to Cover Its Taxes?,” Robert Jeffrey and Robert Arnott found that, during the 10-year period they studied, 21% of actively managed funds beat passives alternative on a pretax basis, while just 7% did so on an after-tax basis.
They concluded: “The preponderance of evidence is so convincing we conclude that the typical approach of managing taxable portfolios as if they were tax-exempt is inherently irresponsible, even though doing so is the industry standard.”
Robert Arnott, Andrew Berkin and Jia Ye, authors of the study “How Well Have Taxable Investors Been Served in the 1980s and 1990s?,” investigated the pre- and after-tax efficiency of actively managed funds, the likelihood of pre- and after-tax outperformance, and the relative size of outperformance versus the relative size of underperformance. The following is a summary of their findings:
- The average fund underperformed its benchmark by 1.75% per year before taxes and by 2.58% on an after-tax basis.
- Just 22% of funds managed to beat their benchmark on a pretax basis. The average outperformance was 1.4%; the average underperformance was 2.6%. However, on an after-tax basis, only 14% of funds outperformed. The average after-tax outperformance was 1.3% while the average after-tax underperformance was 3.2%. The risk-adjusted odds against outperformance were about 17:1.
This story is actually worse than it appears, because the data above contain survivorship bias (33 funds disappeared during the time frame covered by the study). Also, because the study only covered funds with more than $100 million in assets, it’s likely that the survivorship bias is understated. Funds with successful track records tend to attract assets. Funds with poor records tend to lose assets or are “put to death,” never reaching the $100 million threshold used in the study.
Arnott and Berkin, along with Paul Bouchey, updated this study in 2011. They concluded that the typical approach for managing taxable portfolios, acting as if taxes cannot be reduced or deferred, remains the industry standard.
Yet they estimated that the typical active fund needs to generate a pretax alpha of more than 2% per year to offset the tax drag from their active strategies—and most cannot accomplish that feat. The finding of a tax drag in excess of 2% is consistent with the findings from other studies.
An Increasing Level Of Difficulty
In our book, “The Incredible Shrinking Alpha,” my co-author, the aforementioned Andrew Berkin, and I present the evidence demonstrating that, over time, it’s become persistently more difficult to generate pretax alpha.
Ptak’s findings are consistent with the evidence that we presented, as they show an even smaller percentage of active funds are generating after-tax alpha than had been found in prior studies. In other words, while active management has been a loser’s game for decades, the odds of winning are persistently falling because the competition is becoming ever more skillful as the losers (the less skillful) abandon the game.
Given the evidence, it’s not surprising that most mutual fund managers focus on pretax returns. However, ignoring the impact of taxes on the returns of taxable accounts is one of the biggest mistakes you can make.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.