William Bernstein

"For the taxable investor, indexing means never having to say you're sorry."

— William Bernstein, The Intelligent Asset Allocator, 2002

John Bogle

"The miracle of compounding returns is overwhelmed by the tyranny of compounding costs."

— John Bogle, The Little Book of Common Sense Investing, 2007

Michael Jensen

"It is difficult to systematically beat the market. But it is not difficult to systematically throw money down a rat hole by generating commissions (and other costs)."

— Michael Jensen, Forbes Magazine, 1984

James Garland

"It's not brains or brawn that matter in taxable investing; it's efficiency. Taxable investing is a loser's game. Those who lose the least — to taxes and fees — stand to win the most when the game's all over."

— James P. Garland, 1997

Introduction

The Feast
The Feast

Think of a tapeworm. It silently absorbs nutrients intended for your body's health. You may not notice what's happening at first. The tapeworm takes a little here and a little there, not being much of a bother. However, before you know it, the doctor is surgically removing a 50-foot parasite out of your intestines. A similar scenario occurs with active investing. There are silent partners sucking money out of your portfolio little by little. As they slowly siphon off fees and transfer costs, they become fatter and happier like a well-nourished tapeworm.

Silent partners are those who share in your realized or unrealized gains. In any other situation, a silent partner would provide some sort of contribution to aid in your venture, but in the case of your investments, these silent partners lurk in the shadows, adding no value. There are numerous silent partners that take a bite out of realized and unrealized gains on investments. The many sources, individuals and entities that benefit from eating away at an investor's returns pie of wealth are represented in the painting on the right, The Feast. As the family members stand idly in the background looking hungry with perplexed expressions on their faces, their wealth is voraciously consumed by many different entities.

Consider these silent partners:

  • The sales agent or stock broker who earns a commission or load for individual stock and mutual fund trades
  • Federal and state income tax agencies that tax realized gains
  • A fund manager who actively invests stocks in a mutual fund
  • Accountants
  • Firms that charge investment advisory fees
  • Market makers who earn a bid-ask spread on transactions
  • Transfer agents who handle share transfers
  • Mutual fund distributors
  • The brokerage firm that earns interest on margin accounts
More

The Silent Feast

According to a 15-year study conducted by Vanguard founder John Bogle, investors kept 47% of the cumulative return of an average actively managed equity mutual fund, but they kept 87% in a market index fund, as reflected in Figure 7-1. This means $10,000 invested in the average actively managed equity fund grew to $49,000 versus $90,000 in an index fund. That’s a $41,000 drain that pads the pockets of the silent partners in the form of sales commissions, taxes, cash drag, expense ratios, and transaction costs. Cash drag relates to the cash balance held in a fund that is maintained for redemption, and therefore is expected to earn a lower return than the investments.

Figure 7-1

More

Taxes

A later study1 by Bogle analyzed the returns and tax implications of the average equity investor vs. an investor in an S&P 500 Index Fund. Figure 7-2 details the end results for the 25 years from January 1, 1981 to December 31, 2005. The chart shows that $10,000 invested in the average managed equity fund would have grown to post-tax results of only $71,700. The same amount invested in the S&P 500 Index Fund would have grown to a much larger post-tax sum of $159,000.

Figure 7-2

Sad Uncle Sam
Sad Uncle Sam

Figure 7-3 further reveals the contrast between the post-tax returns of both Vanguard index funds and their respective Morningstar categories. From January 1999 through December 2013, a $100,000 investment in the Vanguard 500 Index Fund lost only $10,209 to taxes, while the Morningstar Large Blend category lost $24,530, a $14,321 difference. Looking at another index at the bottom of the chart, the Vanguard Total International Index Fund lost $17,342 to taxes, while the Morningstar Foreign Large Blend category lost $29,536, an $12,194 difference. Note that the annualized returns for the Morningstar categories are upwardly biased due to the impact of survivorship bias. Such contrasts in taxes reveal why passive investing with index funds makes for one very sad Uncle Sam, as seen in the next painting.

Figure 7-3

More

Turnover is Costly in Taxable Accounts

The average active mutual fund has high turnover rates than index funds, creating tax liabilities that erode returns. Figure 7-4 shows six Morningstar categories, which are primarily active funds, compared to passive Vanguard index funds within those categories. Note the large difference in turnover ratios between all Morningstar categories and Vanguard funds.

Figure 7-4

In another study analyzing trading between 1963 and 1992, researchers at Stanford University determined a passively invested dollar would have grown to $21.89 in a tax-deferred account such as an IRA. In contrast, they found a dollar invested by a high tax-bracket individual in an actively managed fund, in a taxable account, grew to just $9.87, almost 55% less! Passive index fund managers minimize portfolio turnover, thereby maximizing unrealized capital gain, and tax-managed index funds virtually eliminate short-term capital gains.2

More

Inflation

Unlike investment costs and taxes, inflation is a variable over which investors have zero control. To hedge inflation risk, some investors have bought Treasury Inflation-Protected Securities (TIPS) which adjust their coupon payments and re-payment of principal based on the Consumer Price Index (CPI). While TIPS may appear to be a no-brainer at first glance, investors should never forget that there is no such thing as free protection from risk, and the cost of this protection comes in the form of a lower long-term expected return relative to nominal bonds. A TIPS buyer is betting that actual inflation will be higher than the “breakeven inflation” incorporated into TIPS prices. One way to mitigate inflation risk is to keep bond maturities short because market interest rates will reflect expected inflation, and as short-term bonds mature, they can be re-invested at the higher market interest rates.

More

Fees

Part of the disparity in ending wealth is due to active managers charging higher fees than passive managers as compensation for their perceived "skill." Figure 7-5 reveals the disparity in expense ratios determined from simple averages of all share classes of funds tracked by Morningstar. The figure portrays the differences of average expense ratios between actively managed funds, passively managed funds, exchange-traded funds (ETFs), and a 60% stocks/40% fixed income Index Portfolio 50. As the chart indicates, the average actively managed mutual fund is nearly twice as costly as the average passively managed mutual fund and is more than four times more costly than the index portfolio. The expense ratio for the average passive mutual fund is higher than the average exchange-traded fund because the former includes high-cost index funds, such as the Nationwide S&P 500 Fund.

Figure 7-5

More

Tax-Managed Funds

Most index funds are tax efficient by their very nature. However, some indexes can be further tax-managed to save you even more in taxes. These tax-managed index funds are very efficient at offsetting realized gains with realized losses, deferring the realization of net capital gains and minimizing the receipt of dividend income. The result is maximized unrealized capital gains that have not yet been realized for tax purposes. Taxes are not paid until a future date when withdrawals are made and the gains then become realized. The benefit is that the unrealized capital gains (profits) remain a growing part of the net asset value of a fund rather than being distributed to the investor. This tax benefit assists in overall wealth accumulation.

More

Minimize the Silent Partners

Index funds provide an excellent opportunity to minimize the negative impact of silent partners. Dimensional and Vanguard are leading providers of tax-managed index funds with offerings in many different equity categories. While fees, transaction costs and taxes eat up active investors' returns, index funds investors maximize asset growth by avoiding the major impacts of costs and taxes. No investment is completely free from silent partners, but passive investors use index funds to retain as much money as possible. Remember, it's not just what you make, it's what you keep that counts.

More
Footnotes:
  • 1John Bogle, The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns (Hoboken: John Wiley & Sons, Inc., 2007).
  • 2Joel M. Dickson and John B. Shoven, "Taxation and Mutual Funds: An Investor Perspective," Tax Policy and the Economy, National Bureau of Economic Research, Vol. 9: MIT Press, 1995.
step 7silent partnersincome taxaccountantsactive managerinvestment advisory feemarket makerstransactionstransfer agentsmutual fund distributorsbrokerage firmjohn boglestudytransaction costssales commissionsexpense ratiostaxescash dragturnoverunrealized capital gaintax-managedshort-term capital gainsinflationfeesskillexchange-traded fundsetfss&p 500index fundsefficientdividend incomeunrealized capital gainsdimensional fund advisorsvanguard

Related Material



Related

Feedback