You vs. Uncle Sam: Taxes & Mutual Fund Performance

You vs. Uncle Sam: Taxes & Mutual Fund Performance

You vs. Uncle Sam: Taxes & Mutual Fund Performance
“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, Retired Chairman of the Jeffrey Company

It is funny how car commercials talk about the fuel efficiency of their vehicles. "The new Kia Optima has an estimated 42 gallons per mile highway." Yes, when it is inside on a track with limited wind resistance. The problem, how many people do you know that drive inside with a perfectly smooth road and no wind resistance?

Similarly, how many taxable investors actually earn the stated performance of mutual funds? The answer should be exactly the same as the first question we posed. This is because investing involves costs, and for those who invest in mutual funds outside of a retirement account, one of the biggest costs that are only itemized for you near the end of the year is taxes - or as we like to refer to as good ole’ Uncle Sam. So how much do taxes matter? Are we talking a few basis points?

A recent research paper by Clemens Sialm from the University of Texas at Austin and Hanjiang Zhang from Nanyang Technological University in Singapore attempted to quantify the benefit of tax-efficient mutual funds versus non-tax-efficient mutual funds as well as identify the variables that lead to better overall tax-efficiency. Here is a quick summary of their findings:

  • Average tax-burden across the entire universe of mutual funds in the United States was 1.12% per year, similar to the average expense ratio (1.21%) for the universe.
  • Average turnover was 88% per year, meaning that the average holding period for a single stock within the fund was approximately 14 months.
  • Tax burden was the highest for actively managed mutual funds (1.14% per year) and tax-managed funds were the lowest (0.27% per year).
  • Mutual funds that follow tax-efficient management strategies (avoiding stocks with high dividend yields, avoiding the realization of capital gains, and accelerating the realization of capital losses) outperformed those that didn’t by 2.26% over 1 year rolling periods, 2.10% per year over 3 year rolling periods, and 1.52% over 5 year rolling periods. This difference is statically and economically significant
  • Interestingly, the before tax returns of mutual funds that followed tax efficient management strategies where not statistically different than those that did not over the same time periods, indicating that the cost and constraints placed on funds that follow tax efficient management strategies do not affect the overall performance of the fund before taxes.
  • There is no evidence that those strategies that are not constrained by tax-efficient management strategies exhibit superior selectivity or timing ability than those that did have tax-efficient management constraints. Variables that do effect overall tax burden are style, expense ratio, and trading costs.
  • Tax burdens are good predictors in overall performance, similar to the relationship that exists between expense ratios and subsequent performance.
  • Funds focused on value stocks have a higher tax burden than those that focus on growth, all else equal
  • Funds that focused on small capitalization stocks had higher tax burden’s than those that focused on large capitalization stocks, all else equal.
  • These trends hold for 3 independent time periods (1990-1997,1998-2002, 2003-2012).

Overall, the authors conclude that, "investment taxes are of similar importance as fund expenses. Surprisingly, we find that mutual funds that impose higher tax burdens on their investors do not offset these tax costs with superior before-tax performance. Rather, tax-efficient funds seem to outperform tax-inefficient funds before and after taxes through superior investment ability, lower trading costs, and careful tax management."

Index Fund Advisors has long advocated for adopting an investment approach that speaks to these conclusions: get diversified, keep costs low, and forget trying to outsmart the market (see article). For our clients, we have utilized tax-managed funds from Dimensional Fund Advisors to help minimize Uncle Sam’s take-home versus their own. The chart below shows the pre-tax and after-tax growth of $10,000 invested in the average actively managed fund versus the S&P 500 for the 25 years ending 12/31/2005.

Understanding the importance of taxes does not end with just choosing a passive strategy, we can increase after-tax returns for our clients by utilizing tax-managed versions of the DFA funds that we like to use in our index portfolios. The chart below shows the estimated before and after-tax returns of tax-managed funds versus their non-tax managed equivalents as well as the estimated tax-savings across our IFA Index Portfolios.

Mutual funds that adopt tax-efficient management strategies tend to be slightly more expensive than their counterparts that do not adopt tax-efficient management strategies, especially for passively managed index funds. Further, many investors have turned to exchange traded funds (ETFs) as their passive vehicle of choice since they do not distribute capital gains to investors at the end of the year. At IFA, we believe that the tax-efficient funds we have utilized for our portfolios have provided a net benefit to our clients versus comparable ETFs. We had written a previous article that discussed this topic in more depth.

Like driving our cars on actual roads, outside, with wind resistance, the returns experienced by investors after taxes are dramatically different than performance stated by mutual fund companies. While many highlight the importance of keeping expense ratios low, trading costs have an almost equal impact on overall performance. Keeping costs to a minimum, especially in the corners of the market that are expected to reward investors over the long term (small cap and value stocks), increases the potion of the pie that goes to our clients versus Uncle Sam’s. Not all passively managed strategies are equal after-taxes and IFA is continuously analyzing the many offerings out there to make sure that our clients taking full advantage of what has been proven to deliver the best results.

Check Mate Uncle Sam!