Step 7: Silent Partners

Recognize the partners in your returns

7.2

Definition

7.2.1

Silent Partners

There are numerous silent partners that take a bite out of realized and unrealized gains on investments. These partners include:

1. The sales agent or stock broker who earns a commission or load for individual stock and mutual fund trades
2. Federal and state income tax agencies that tax realized gains
3. The fund manager who actively invests the stocks in a mutual fund
4. Accountants
5. Firms that charge investment advisory fees
6. Market makers who earn a bid-ask spread on transactions
7. Transfer agents who handle the share transfers for all those trades
8. Mutual fund distributors
9. If applicable, the brokerage firm that earns interest on margin accounts

7.3

Problems

7.3.1

Active Investors are Unaware of all the Costs

Each partner's bite adds up to claim a significant share of an investor’s return. The tax effects on actively managed mutual funds are rarely evident from the reported data. Since investors do not feel the tax bite until the following April 15th, most investors do not consider more than 17% of their pre-tax returns as lost to taxes. The effect reinforces the substantial value of passively buying and holding stocks in an index fund.

Table 7-1

According to a study conducted by John Bogle over a sixteen-year period, investors only get to keep 47% of the cumulative return of the average actively managed mutual fund, but they keep 87% in a market index fund. This means $10,000 invested in the index fund grew to $90,000 vs. $49,000 in the average actively managed stock mutual fund. That is a 40% gain from the reduction of silent partners....everyone should take that! See Figure 7-1.

Figure 7-1

Table 7-2 shows how the various "silent partners" could have different impacts on the annual returns of an average mutual fund and the Wilshire 5000 Index Fund from 1984 - 1998 with an estimated equal fund return of 16.9%. Note that investor return would have been 15.8% in the index fund vs. 11.2% in an average mutual fund.

Table 7-2

A more recent study by Bogle covers the 25-year time period from 1980 through 2005, analyzing the returns and tax implications of the average equity investor vs. an investor in an S&P 500 Index Fund. The study found that the average annual return of the average actively managed equity fund was 10%, while the average annual return of the S&P 500 Index Fund was 12.3%. The study’s striking conclusion showed that despite the higher returns earned by the index investors, they were actually subjected to lower taxes of just 0.6%, a striking contrast to the 1.8% tax burden incurred by the average equity fund investor.

Figure 7-A details the end result, showing that S&P 500 Index Fund investors enjoyed an after-tax annual return of 11.7%, while the average equity investor settled for a much smaller annual return of 8.2% — a 3.5% difference. This means that $10,000 invested in the average managed equity fund for the 26-year time period would have grown to $108,347 before federal tax considerations, with post-tax results of just $71,727 — a 33.8% tax bite. Meanwhile, $10,000 invested in the S&P 500 Index Fund would have grown to a much larger pre-tax sum of $239,570, with investors enjoying an after-federal tax sum of $201,084 with just 16.1% going to federal taxes.

Figure 7-A

Figure 7-B

7.3.2

Taxes

Now let’s take a look at how the tax-managed index funds can almost eliminate Uncle Sam’s big bite out of your returns in taxable accounts. No wonder he looks so sad.

As indicated above, most index funds are very tax efficient. However, some indexes can be further tax managed to squeeze out even more taxes. Tax-managed index funds make an already tax efficient investment even more tax efficient by offsetting realized gains with a realized loss then deferring the realization of net capital gains and minimizing the receipt of dividend income. The result is minimal taxable distributions to investors.

See the results for year 2008 in this Schedule of Distributions.

In a telephone survey by the Dreyfus Corporation, one thousand mutual fund investors were questioned about their tax knowledge. Eighty-five percent of respondents claimed taxes play an important role in investment decisions, but only 33% felt that they were knowledgeable about the tax implications of investing. Eighty-two percent were unable to identify the maximum rate for long-term capital gains.

Taxes on realized (distributed) capital gains, dividends, and interest can be significant. It is estimated that the average active mutual fund investor loses about three percentage points of return to taxes every year. The more an investor earns in active mutual funds, the higher the taxes. This reduces the potential for wealth, which defeats the purpose of investing. A study conducted by Stanford University measured the performance of 62 equity funds for the period from 1963 through 1992.

It found that although each dollar invested in this group of funds would have grown to $21.89 in a tax-deferred account, the same amount of money invested in a taxable account would have produced only $9.87 for a high-tax-bracket investor. Taxes cut returns by 57.5%! Index funds, however, have low portfolio turnover and their capital gains distributions are also very low, thereby reducing the impact of taxes. See Table 7-3.

Managers of Active Funds Seem to Manage Money as if Taxes do not Matter

Historically, many active mutual fund managers managed pension plans and other tax-free pools of money, so they did not have to worry about the tax impact of their investment trades. As a result, managers of active funds today often disregard the high taxes generated by their stock picks and market timing, not to mention the adverse effect on fund performance. Realized capital gains taxes are not reflected in active mutual fund performance ratings thereby catching the average active mutual fund investor by surprise.

Taxes do Matter

Instead of being distributed and taxed, unrealized capital gains are profits that have not yet been realized for tax purposes; taxes need not be paid on these gains. Unrealized capital gains remain a growing part of the net asset value of a fund’s share rather than being distributed to the investor. The index fund manager minimizes portfolio turnover, and so maximizes unrealized capital gain. When stocks in an active fund increase in value and are sold for a profit by the fund’s manager, the result is that the fund actually realizes gains as opposed to simply reporting an increase in the value of the portfolio, and investors pay both ordinary income and capital gains taxes on those distributions. On the other hand, by the time an investor is ready to realize an investment in an index fund, it will be a long-term capital gain, untaxed for years. Realized long-term capital gains have a much lower tax rate.

As might be expected, taxes affect active fund performance, not only earnings. Stanford University released the results of a 30-year study in 1993 that examined the difference between the average pre-tax, after-tax, and liquidation performance of 62 actively managed stock mutual funds. Pre-tax performance assumes reinvestment of all distributions, after-tax assumes reinvestment of distributions left after taxes have been paid, and liquidation is selling out completely and paying all taxes, rather than reinvesting in the fund. The study also took into account differing tax brackets, whether high (55% taxes paid), medium (41%) or low (25%). According to the study’s results, between 1963 and 1992 it was found that a high tax bracket investor who reinvested after-tax distributions ended up with an accumulated wealth of 45% of the fund’s published performance. Investors in a middle tax bracket realized 55% of published performance.

As mentioned earlier, actively managed mutual fund advertisements and published ratings feature only pre-tax returns, often misleading investors. In fact, Robert Jeffrey and Robert Arnott proved with their 10-year study titled “Is Your Alpha Big Enough to Cover its Taxes?” that on an after-tax basis, index funds outperformed 97% of active mutual funds. They also found that although 71 active funds tried to beat the market with high turnover efforts, the added returns did not outweigh the resulting taxes.

7.3.3

Turnover

Turnover is Costly in Taxable Accounts

A number of studies show the average active mutual funds have higher turnover rates, creating tax liabilities that erode returns. Table 7-3 shows just how carried away fund managers can get with buying and selling equities. The Prasad Growth Fund had 1,135% turnover in 2011, as compared to the Schwab S&P 500 Index at 3% turnover.

Table 7-3

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 gains, and tax-managed index funds virtually eliminate short-term capital gains.

7.3.4

Inflation

Unlike investment costs and taxes, nothing can be done about inflation.

Unlike investment costs and taxes, nothing can be done about inflation. Inflation is an equal opportunity destroyer of an individual's purchasing power. Inflation has averaged 2.34% per year over the last ten years, which does not seem too significant. However, a 2.34% inflation rate is only negligible in the short term but is terribly erosive in the long term, with purchasing power being cut by 21% for the ten years ending December 2010 and by 39% for the 20-year period with the same ending date. A certain amount of loss from inflation is incurred whether assets are invested in stocks or bonds, but investing as large a portion of an investment portfolio in stocks as soon as possible - and for as long as possible - is the best way to outpace inflation. Stocks have grown in value more than bonds over the years and have been the best antidote for inflation.

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Step 1: Active Investors

Definitions

Problems

Solutions

Step 2: Nobel Laureates

Definitions

Problems

Solutions

Step 3: Stock Pickers

Definitions

Problems

Step 4: Time Pickers

Definitions

Problems

Step 5: Manager Pickers

Problems

Step 6: Style Drifters

Definitions

Problems