Taxes: What a Drag—on Your Portfolio’s Profits

Do you know how much return clients invested in taxable accounts lose to taxes each year? While many investors scrutinize their portfolio’s pre-tax return and net expense ratio, taxable investors should balance that data against the after-tax return. Remember, it’s not what you earn, but what you keep that counts! Tax headwinds have the potential to get in the way of investors achieving their long-term financial goals.

To get a sense for these potential tax headwinds, we analyzed the average annual impact of taxes over the last 10 years ending January 31, 2014 on the Morningstar U.S. equity investment products data, which  includes both actively-managed U.S. equity investment products and passively-managed (i.e., index and exchange-traded) U.S. equity investment products across market cap sizes and styles. We used a 10-year time frame in order to reduce the impact of the 2008 downturn, which has made many U.S. equity investment products appear tax-efficient in the past five years when, in reality, they were simply working off capital losses they accumulated in 2008.

Take 1: Tax drag on the average active and passive U.S. equity investment products

(Tax Drag = Pre-Tax Return Less After-Tax Return)

For the 10 years ending January 2014, the average fund in the universe we analyzed surrendered 1.02% of its return to taxes each year and had a net expense ratio of 1.05%

This means that the impact on total return of taxes and the expense ratio are nearly equal in this universe – even though many investors give the tax impact less attention.

Digging deeper into the tax impact, you find that the compounding effect of the 1.02% average annual tax drag represents a 10.7% return degradation over 10 years. That’s not a small number! Add to that the fact that tax rates recently increased for many taxpayers, likely making the annual tax drag look worse going forward.

Take 2: Tax drag on the average U.S. equity large cap and small cap investment products

Next, we sliced the same Morningstar data by cap size (large cap and small cap) to see whether the tax drag and after-tax return dynamics differed for investment products depending on the cap size of the securities they invest in.

Within large cap, the median annualized tax-drag over the last 10 years was 0.86% and within small cap, the annualized tax drag was 1.15%.

U.S. equity investment products: 10 year tax drag

Take 3: All about after-tax returns

But avoiding a tax or minimizing taxes is not a goal unto itself. The larger objective is higher ending after-tax wealth. Beyond the tax-drag, we also analyzed their after-tax returns by market cap size for the 10 years ending January 2014 and found a wide range among investment products in both the U.S. equity Large Cap and U.S. equity Small Cap segments. For instance, within Small Cap, the annualized range was over 14% and the difference between the median manager and the worst manager was over 9%. Clearly, picking the right product (or avoiding the wrong one) can make a meaningful difference.

U.S. equity investment products: 10-year after-tax return

The bottom line

Again, avoiding taxes or minimizing taxes is not a goal unto itself. After all, it’s likely worse to pay no tax because there may have been no return than to pay a tax on positive returns. So, a more sensible goal should be to maximize after-tax returns – especially at a time when capital gain distributions have increased for many investment products and tax rates have risen for many investors.

Start by checking the after-tax returns of the investment products in your clients’ portfolios (all fund companies are required to publish their after-tax returns and Morningstar posts them, too). And remember, many investment products have appeared tax-efficient the last 5 years because of the capital losses they accumulated in 2008. So make sure you understand how the U.S. Equity investment products achieved its after-tax return: was it by design or was it incidental?

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To see this post in its original form, with more information and full disclosures, visit Russell's Helping Advisors blog

http://blog.helpingadvisors.com/2014/03/25/tax-efficient-municipal-bond-portfolio/

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