Chapter Six

Taxes Are Costs, Too

Don’t Pay Uncle Sam Any More Than You Should.

 

 

 

 

WE STILL AREN’T THROUGH with these relentless rules of humble arithmetic—the logical, inevitable, and unyielding long-term penalties assessed against stock market participants by investment expenses and the powerful impact of inflation—that have slashed the capital accumulated by mutual fund investors. As described in Chapter 4, the index fund has provided excellent protection from the penalty of these costs. While its real returns also were hurt by inflation, the cumulative impact was far less than on the actively managed equity funds.

But there is yet another cost—too often ignored—that slashes even further the net returns that investors actually receive. I’m referring to taxes—federal, state, and local income taxes.¹⁴ And here again, the index fund garners a substantial edge. The fact is that most managed mutual funds are astonishingly tax-inefficient, a result of the short-term focus of their portfolio managers, usually frenetic traders of the stocks in the portfolios they supervise.

Managed mutual funds are astonishingly tax-inefficient.

The turnover of the average equity fund now comes to about 100 percent per year. (In fairness, based on total assets rather than number of funds, the turnover rate of actively managed funds is 61 percent.) Industrywide, the average stock is held by the average fund for an average of just 12 months. (Based on equity fund total assets, only 20 months.) Hard as it is to imagine, from 1945 to 1965, the turnover rate averaged just 16 percent per year, an average holding period of six years for the average stock in a fund portfolio. This huge increase in turnover and its attendant transaction costs have ill-served fund investors.

This pattern of tax-inefficiency for active managers seems destined to continue as long as (1) stocks rise, and (2) fund managers continue their hyperactive patterns of short-term trading. Let’s be clear: Most fund managers, once focused on long-term investment, are now focused on short-term speculation. But the index fund follows precisely the opposite policy—buying and holding forever, and incurring transaction costs that are somewhere between infinitesimal and zero.

So let’s pick up where we left off two chapters ago, with the net annual return of 10.0 percent for the average equity fund over the past 25 years can be compared with the 12.3 percent return for the S&P 500 Index fund. With the high portfolio turnover of actively managed funds, their taxable investors were subject to an estimated effective annual federal tax of 1.8 percentage points per year (state and local taxes would further balloon the figure), reducing the after-tax annual return to 8.2 percent (Exhibit 6.1).

Despite the higher returns that they earned, investors in the index fund were actually subjected to lower taxes—in fact, at 0.6 percentage points, only about one-third of that tax burden—bringing their after-tax return to 11.7 percent. Compounded, the initial $10,000 investment grew by just $61,700 after taxes for the active funds, nearly 60 percent less than the $149,000 of accumulated growth in the index fund, a loss of some $87,300.¹⁵

EXHIBIT 6.1 Index Fund versus Managed Fund: Profit on Initial Investment of $10,000, 1980-2005

What’s more, just as fund expenses are paid in current dollars, so is your annual tax bill. When we calculate the accumulated wealth in terms of real dollars with 1980 buying power, investor wealth again contracts dramatically. The annual real return of the average equity fund now drops to 4.9 percent, less than 60 percent of the 8.4 percent actual return of the index fund. Compounded, the real after-tax accumulation on that initial $10,000 came to $65,100 for the index fund, nearly three times the $23,100 for the active equity index fund.

Even with the more subdued returns earned in the postbubble era, actively managed funds persist in foisting this extraordinarily costly tax inefficiency on their shareholders. While the net annual return of the average equity fund was 8.5 percent over the past decade (1996 to 2005), the tax bill consumed fully 1.7 percentage points of the return, reducing the net fund return to just 6.8 percent.

I hesitate to assign the responsibility for being “the straw that broke the camel’s back” of equity fund returns to any single one of these negative factors. But surely the final straws include (1) high costs, (2) the adverse investor selections and counterproductive market timing described in Chapter 5, and (3) taxes. Whatever way one looks at it, the camel’s back is surely broken. But the very last straw, it turns out, is inflation.

Fund returns are devastated by costs, taxes, and inflation.

When we pay our fund costs in current dollars, year after year—and that’s exactly how we pay our fund expenses and our taxes on fund capital gains (often realized on a short-term basis, to boot)—and yet accumulate our assets only in real dollars, eroded by the relentless rise in the cost of living that seems imbedded in our economy, the results are devastating. It is truly remarkable—and hardly praiseworthy—that this devastation is virtually ignored in the information that fund managers provide to fund investors.

A paradox: While the index fund is remarkably tax-efficient in managing capital gains, it turns out to be relatively tax-inefficient in distributing dividend income. Why? Because its rock-bottom costs mean that nearly all the dividends paid on the stocks held by the low-cost index fund actually flow directly into the hands of the index fund’s shareholders. With the high expense ratios incurred by managed funds, however, only a tiny portion of the dividends that the funds receive actually find their way into the hands of the fund’s shareholders.

Here is the unsurprising and ever relentless arithmetic: the annual gross dividend yield earned by the typical active equity fund before deducting fund expenses is about the same as the dividend yield of the low-cost index fund—1.8 percent in late-2006. But after deducting the 1.5 percent of expenses borne by the typical active fund, its net dividend yield drops to just 0.3 percent (!) for its owners. Fund operating costs and fees confiscate fully 80 percent of its dividend income, a sad reaffirmation of the eternal position of fund investors at the bottom of the mutual fund food chain.

The expense ratio of a low-cost index fund is about 0.15 percent, consuming only 8 percent of its 1.8 percent dividend yield. The result: a net yield of 1.65 percent to distribute to the passively managed index fund owners, a dividend merely 5.5 times as high as the dividend yield of 0.3 percent on the actively managed fund.

For taxable shareholders, that larger dividend is subject to the current 15 percent federal tax on dividend income, consuming about 0.27 percentage points of the yield. Paradoxically, the active fund, with an effective tax rate of just 0.045 percent (15 percent of the 0.3 percent net yield), appears more tax efficient from a dividend standpoint. But the reality is that the tax imposed by the active managers in the form of the fees it deducts before paying those dividends has already consumed 80 percent of the yield. The wise investor will seek the dividend “tax-inefficiency” of the index fund dividend rather than the “tax-efficiency” of most actively managed funds engendered by their confiscatory operating costs.

Don’t Take My Word for It

Consider these words from a paper by John B. Shoven, of Stanford University and the National Bureau of Economic Research, and Joel M. Dickson, then of the Federal Reserve System: “Mutual funds have failed to manage their realized capital gains in such a way as to permit a substantial deferral of taxes (raising) investors’ tax bills considerably. . . . If the Vanguard 500 Index Fund could have deferred all of its realized capital gains, it would have ended up in the 91.8 percentile for the high tax investor” (i.e., it outpaced 92 percent of all managed equity funds).

Or listen to investment adviser William Bernstein, author of The Four Pillars of Investing: “While it is probably a poor idea to own actively managed mutual funds in general, it is truly a terrible idea to own them in taxable accounts . . . (taxes are) a drag on performance of up to 4 percentage points each year . . . many index funds allow your capital gains to grow largely undisturbed until you sell. . . . For the taxable investor, indexing means never having to say you’re sorry.”

And Dr. Malkiel again casts his lot with the index fund: “Index funds are . . . tax friendly, allowing investors to defer the realization of capital gains or avoid them completely if the shares are later bequeathed. To the extent that the long-run uptrend in stock prices continues, switching from security to security involves realizing capital gains that are subject to tax. Taxes are a crucially important financial consideration because the earlier realization of capital gains will substantially reduce net returns. Index funds do not trade from security to security and, thus, they tend to avoid capital gains taxes.”