Taxes: Your Largest Expense

Font Size:
Print
Email

© Brendan Ross

For wage earners, income taxes are easy to identify

If you earn an income, then you are aware of the painful gap between your salary and your take home pay.   Pay stubs make clear the relationship between gross and net pay.

The taxes investors pay are hidden away

For Capitalists the story is very different.  Every snapshot of your portfolio will portray growth (or losses) prior to taxes being removed.  In fact, you will likely NEVER see a graph or chart that shows losses due to taxes.  Your reckoning with the tax man happens once a year, buried in the 1099 you send your accountant.

Three important topics

  • Why active management incurs more taxes than index funds
  • What the long term consequences are of paying taxes now versus later
  • How actively managed funds have performed versus index funds, after taxes

Taxes on capital gains

Capital Gains taxes are paid when an asset is sold.  The idea is that you pay the government a portion of the gain you receive from selling something for more than you paid.   While it may sound absurd that you should owe the government any money for your successful bartering, breaking these rules involves jail time.

Higher taxes for short term investors

In its wisdom, the US government has many rates for Capital Gains, however just two are relevant to higher-income investors trading in stocks and bonds.   For assets held longer than one year, you’ll pay 15% (at least through 2010).  For assets held less than one year, you’ll pay ordinary income taxes, which for most people hiring investment advisors is going to be around 40% - 50% depending on which state you live in.  We’ll use 40% in the rest of this article as the short term capital gains tax rate.

The gap between the 40% short term rate and the 15% long term rate is huge.  If you could invest so as to trigger only the 15% rate on all gains, you’d be miles ahead of anyone getting hit with the 40% rate.

How Active Management raises your taxes

The very nature of Active Management requires frequent buying and selling, and active funds generally have an 80% turnover.  This means that each year about 80% of what is in the fund on January 1 has been replaced by December 31.  Alternately, a fund could have a small portion of its portfolio churn many times a year.  Either way, you’re paying short term capital gains.  Index funds average closer to a 3-8% turnover.

Most conscientious investors are buying-and-holding their mutual funds.  They expect to pay taxes when they sell their fund, probably many years hence.  What is counter-intuitive is that taxes are triggered when the mutual fund manager makes trades, NOT just when you do. 

How to turn 10% growth into 6% growth

Let’s take an extreme example, just so we can hammer this difficult point home.  Let’s say that you put $1,000 in a mutual fund, and your mutual fund manager bets it all on Ford, putting 100% of the fund’s assets into Ford stock on January 1.  Let’s say that Ford goes up by 10%, and your fund manager sells Ford on December 31, just shy of the one year mark, switching all of his money into Boeing.  Despite the fact that you did nothing but gloat over your $100 gain, you now owe the government $40 in short term capital gains taxes.  You can expect your mutual fund to issue you a 1099 showing that you must pay the government $40.  If you have no other income, you must now sell off a portion of your mutual fund to pay for this gain.  Let’s assume you do that, selling off $40 in funds.  You now have $1,060, for a net 6% gain.  Not quite as nice, is it? 

Doing it every single year will hurt a lot

Extending the story further, imagine that your fund manager does this year after year, consistently betting the farm and netting 10% increases, all of which trigger short term capital gains taxes of 40%.  Each year you sell some stock to pay for the taxes, and each year your capital grows by 6%. 

Although this oddball manager has 100% turnover, he’s not far off the 80% turnover that actively managed funds average. 

In 25 years, you can turn $1,000 into either $4,300 or $9,360.

Finally, after 25 years, you retire.  You sell your portfolio, which is now worth $4,300.  Because you’ve paid taxes on your gains every year, you owe no taxes on this $4,300.  Not bad, you think.  But you’re wrong. 
Let’s say you bought an index fund that had 0% turnover.  This particular fund simply bought a big basket of stocks and kept them forever.   Let’s assume you also get 10% returns, same as with Ford and Boeing.  After 1 year you have $1,100.  You pay no taxes because you have no turnover.   You sell off nothing, since you have no taxes to pay, so you achieve a compound annual growth rate of 10%.

After 25 years, your index fund investment has grown to $10,830!  When you sell, you pay taxes based on the difference between the $10,830 and the $1,000 you started with.   You pay your 15% taxes and end up with $9,360.  Much better.

In this extreme example, the person paying taxes at the end of the 25 years earned 9.3x what they invested, whereas the person paying taxes all along achieved only 4.3x.

The destructive power of “decompounding”

This example shows the destructive power of “decompounding”.  While the reality is less drastic, the same principles apply:  every bit of turnover triggers taxes, and every penny of taxes paid now decompounds your long term growth.

These differences are not hypothetical

Now let’s look at some research to see how our hypothetical scenario compares with reality.
James Garland studied the S&P 500 from 1970 through 1995 in a paper titled “The Tax Attraction of Tax-Managed Mutual Funds” (Journal of Investing, Spring 1997).    He made the following assumptions:

  • The actively managed fund achieved the same returns as the index fund.  (Note that actively managed funds return 1.8% lower than their index, on average)
  • Active fund turnover was 80% vs 3% for the index fund
  • Active fund expenses were 1% (in reality the average is 1.5%)

Share of returns to Investor in Actively Managed Fund vs Index Fund

Over this time period the S&P 500 went from 92 to 615.  An investment of $1,000 would have worked out as follows:

Comparing Index Fund, S and P 500, and Active Fund

As we’ve done elsewhere, let’s look at one more study before turning the remaining skeptics over to our recommended reading.

Study:  In real life, active managers simply don’t beat indexes

The next piece of analysis we’ll look at is completely non-theoretical.  Robert Arnott compares mutual fund performance to an actual index fund, the Vanguard 500.   Arnott’s article is titled “How Well Have Taxable Investors Been Served in the 1980s and 1990s” (The Journal of Portfolio Management, Summer 2000). 

Arnott’s results included only those funds that survived the entire periods he examined.  This means that funds which did poorly and were shut down are not included.  In the industry, this is called “survivorship bias”.  When reviewing the dismal picture below of actively managed funds, readers should keep in mind that survivorship bias makes the results appear better than in reality.  Funds typically disappear by being swallowed into new funds, their bad results washed away forever.

Table showing most funds fail vs Vanguard 500 before and after taxes

Note that not only are there few funds beating the Vanguard 500, but the average amount by which they won is much smaller than the average amount by which the losing funds lost.  Were you a bettor (and if you’re investing actively you ARE) then you’d face long odds against winning, and the carrot for winning would be much smaller than the stick you’d face if you lost.

This study ignores state taxes.  If you live in a state with taxes, your results will be even worse.

Quotes on the disappointing performance of actively managed funds:

  • “The way that taxable assets are managed poses a serious problem for the taxable investor.  Most mutual funds do a disservice to their clients by ignoring or dismissing the taxes triggered by their trades.”
  • “For the investor who chooses, in the words of Warren Buffet, to “sit quietly” and take the long-term view, the mutual fund world offers little comfort.  What is needed is a change in mind-set, among both fund managers and their clients.”

Trading individual stocks is just as bad

On a final note, these studies all dealt with mutual funds.  Anyone actively trading individual stocks will face these same negative consequences.  If you’re currently consuming any investment newsletters, scan them for any mention of taxes.  Along with transaction costs, those stats are usually swept under the rug.