TAX EFFICIENCY AND ACTIVE INVESTING

 

Tax-efficiency is at the heart of the RVW IntelliBETA® Wealth Management System. Our portfolios typically generate minimal tax cost, allowing the assets to compound in a tax-advantaged environment. And when they are liquidated, it’s usually at the (lower) long term capital gains rate. Strategic ETF based investing is not only superior to most active strategies in performance, but is particularly advantageous in taxable accounts which are subject each year to pass-through of capital gains and dividend taxes at the Federal level and in most States. Active managers must "turn over" money far more rapidly than passive managers as they try to boost performance by trading stocks or timing markets.

Consequently, investors in actively managed funds or portfolios are likely to realize higher capital gains taxes than passive and index investors. Though there is wide variation, the average actively managed portfolio has a turnover rate of roughly 80% per year, while it is around 10% for passive and index portfolios. There is substantial yearly variation in capital gains depending upon market returns. For many asset classes and many years, the ETFs selected by RVW pass-through of capital gains has totaled below 2% of value.

Several studies have examined the deleterious effect of high turnover rates on after-tax portfolio returns, and their effect is substantial. A Stanford study compared median pre-tax and after-tax performance for 62 actively managed stock mutual funds over a 30 year period, 1963-1992. A high tax bracket investor received less than half of the pre-tax performance, 45%, and a medium tax-bracket investor, 59%. Further, assuming they cashed out at the end, paying further capital gains upon liquidation, these figures dropped to 42% and 55% respectively.

Over even short time frames, the effects of high turnover and taxes on returns is still substantial. Morningstar looked at returns for actively managed U.S. equity funds for 1992 through 1996, five years. Investors in the highest Fed and capital gains tax rates received, on average, a little over 70% of the total returns they would have received had the monies been in a tax-deferred account. Of course, Wall Street and mutual funds report performance figures before taxes and liquidation. In fact, mutual fund managers are hired or fired by firms and clients naively comparing their absolute performance with other managers, and tax consequences and real after-tax returns are often ignored. A study by David Booth compared the after-tax performance of two stellar active funds, Janus and Fidelity Magellan, for the 15 year period ending in 2000. Both funds outperformed the S & P by 2% annually, but, after taxes trailed it by 0.4%. Tax-efficiency matters and passive portfolios maximize it.

Another study published in 1993 looked at the pre-tax and after-tax performance of 72 funds classified by Morningstar as large growth or growth and income. This analysis included funds in existence for the 10 year period from 1982 through 1991, and included the Vanguard S & P 500 index. On a pre-tax basis, the Vanguard index outperformed 79% of the actively managed funds. On an after-tax basis, it outperformed 86% of the active funds. Add in mutual fund expenses, and only 2 of the 71 funds, 2.8%, outperformed the index. It is obvious from the above studies that investors with equity assets in taxable accounts will benefit significantly from using indexes. It's also important to note that capital gains taxes and tax-efficiency will vary from year to year in both active and passive portfolios.

Some advisory firms recommend tax-loss harvesting. We do not generally promote the practice but will selectively tax-loss harvest upon client request or where we deem it appropriate. This strategy involves micromanaging index funds by realizing losses in index funds that have gone down in value, and using them to offset pass-through gains in funds which have produced them. 


 

IMPORTANT: This website is only intended for clients and interested investors residing in states in which the Adviser is qualified to provide investment advisory services, and is not an invitation to invest. Please contact us to find out if we are qualified to provide investment advisory services in the state where you reside and to learn more about what we do.

THIS INFORMATION IS BELIEVED BY US TO BE ACCURATE BUT MAY CONTAIN ERRORS. IT IS GENERIC AND MAY NOT BE SUITABLE TO YOUR PARTICULAR SITUATION. DO NOT RELY ON IT. NEVER INVEST WITHOUT CAREFULLY REVIEWING OFFERING DOCUMENTS, ON WHICH ALONE YOU SHOULD RELY. ALL INVESTING ENTAILS RISK. CAPITAL NOT GUARANTEED.

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