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.
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%).
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.