Turnover is Costly in Taxable Accounts

The average active mutual fund has higher turnover rates than index funds, creating tax liabilities that erode returns. Figure 7-4 shows six Morningstar categories, which are primarily actively managed funds, compared to 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.1

    -1 Joel 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 7Turnoverunrealized capital gaintax-managedshort-term capital gains