“None of my clients are taxable. Once you introduce taxes, active management probably has an insurmountable hurdle.”
– Ted Aronson, Aronson & Partners
As we conclude another tax season, we believe it is appropriate to reiterate one of Financial Coach’s Pillars of Investment Philosophy, Tax and Cost management. For investors with taxable accounts, that is, investments that are not held in IRAs or 401ks – it’s important to remember that after tax results are the only returns that should matter. Mutual fund returns that you would see on a statement, website or elsewhere are typically reported on a pre-tax basis, and it’s done so because not every individual has the same effective tax rate. Also, most funds can be held in any type of account, whether taxable or tax deferred. So on an after tax basis, fund performance is usually a uniquely personal calculation.
A variety have studies have demonstrated that taxes can be an even bigger drag on performance than fund expenses, but most investors succumb to a sort of “mental accounting” that separates investment performance from the associated tax bill the following spring. We think that’s a mistake, because “tax drag” is very real phenomenon that can have a big negative impact on your portfolio.
In fact, a very interesting recent study out of the University of Texas at Austin has concluded that “tax efficient asset managers exhibit superior after-tax returns, as expected. What was surprising is that those same mutual funds regularly outperformed the market before taxes as well¹.”
We suspect that this can be explained by behaviors that tax efficient mangers likely employ, namely, patience and discipline, low turnover, and a longer term focus.
By their nature, actively managed mutual funds typically trade more often than index funds, and are therefore more likely to generate taxable gains that by IRS rules are required to be passed on to all the fund’s investors. Unfortunately, capital losses cannot be passed on and can only be used by the fund to offset future capital gains within the fund. One of the reasons we are such proponents of index funds is that, on balance, they are more tax efficient, and we understand how important that is.
Every dollar the IRS collects from you is a dollar that never will have the opportunity to earn the market’s returns. This is one reason that tax efficiency is an important criterion that we look for when considering investment options for our client’s taxable accounts.
As always, thank you for your trust and confidence in us. Your feedback is always welcome.
Michael Traynor CFA®
Chief Investment Officer
¹Clemens Sialm, co-author, Tax-Efficient Asset Management: Evidence from Equity Mutual Funds, February 26. 2015