The Certain Drag on Performance – Taxes
Advice from Ben Franklin and David Swensen
About this time a few years ago, we wrote about the Certain Drag on Performance in a series for Institutional Investor. Our certainty in the title derives from a famous Ben Franklin quote…
“In this world nothing can be said to be certain, except death and taxes.”
No one likes to talk about the death part of this saying and, aside from our accounting friends, not many people enjoy conversations about taxes either.
When investing, though, the tax bills due on the investments and trades that managers implement are large detractors from the final returns that taxable investors receive – they might be thought of as a significant fee that Uncle Sam makes sure is certain.
The late David Swensen, the long-time Chief Investment Officer of Yale’s Endowment, strove to drive home the importance of tax drag when he made this strong statement in his book, Unconventional Success…
“The management of taxable assets without considering the consequences of trading activity represents a highly visible yet little considered scandal.”
Despite Swensen’s bold warning, the impact of taxes on final investor returns hasn’t been discussed that often, especially in terms that are easy to follow. What has been published has largely been written for tax or academic audiences.
This has been changing some in studies published by firms like Aperio, which we summarized in a piece for the Trust & Estates Journal, What Would Yale Do If It Was Taxable?. As the title hints at, the alternative and active management heavy endowment models many suggest are appropriate for high-net-worth taxable investors don’t look so great on an after-tax basis.
Encouragingly, we also have new, easy-to-follow work from a division of Dow Jones, SPIVA, that diligently tracks the performance of active investment managers compared to indices.
We’ve written before about SPIVA’s work, which has highlighted the persistent underperformance of active managers against their benchmarks and the fact that even those who may do well from time to time trail off and have not been able to consistently outperform.
Now for the first time, SPIVA has evaluated the long-term, after-tax performance of active managers compared to their best-fit indices. The following is what they found:
- 98% of All U.S. actively managed funds underperformed on an after-tax basis over a 10-year period
In addition, SPIVA included the chart and the quote below, which provide a comparison of the Pre-Tax and After-Tax returns of the S&P 500, which index funds can track within a few tenths or even hundredths of a percentage point, versus all domestic funds, all large cap, and large cap core active funds, respectively.
“Adjusting the [U.S. All-Cap] S&P Composite 1500 and [U.S. Large-Cap] S&P 500 for tax resulted in a less than 0.5% annual impact over all the time periods studied.”
On the other side…
“The average after-tax 10-year annualized returns for All Domestic funds, All Large-Cap funds and Large-Cap Core funds lagged pre-tax averages by 2.9%, 1.6% and 1.5%, respectively.”
We can already hear some active fund managers quibbling at SPIVA’s approach, and we agree that the tax assumptions used in these types of calculations are key.
Fortunately, to help address these quibbles, our friends at Alpha Architect have not only written a nice summary of S&P’s methodology, but have also provided a summary of many other prominent research pieces that touch on Franklin’s and Swensen’s tax warnings.
What did all the papers that Alpha Architect (AA) highlighted consistently show in one form or fashion?
It might be best summed up in the quote below from a Barron’s article that the AA team mentioned. As one of the most prominent institutional active managers of our time, Ted Aronson, the founder of Aronson, Johnson, and Oritz (now known as AJO Vista) said…
“None of my clients are taxable. Because, once you introduce taxes… active management probably has an insurmountable hurdle… I am sorry to say.”
SPIVA’s work discusses how tax drag could be minimized if managers focused more on the deferral of capital gains and loss harvesting, which some of the newly touted, so-called tax-efficient actively managed funds strive to do. As the AA overview mentions and others have shown, however, the net of all fees, tax-alpha promises of these active funds haven’t consistently held up either.
The conclusion from all this brings us back to another legendary David Swensen quote. When asked in an NPR interview for his final thoughts on how taxable investors should construct portfolios Swensen said…
“When you look at the results on an after-fee, after-tax basis, over reasonably long periods of time, there’s almost no chance that you end up beating an index fund. The odds are 100 to 1.”
We agree.
Related Reading:
What Would Yale Do If It Was Taxable? – Trust & Estates Journal – Preston McSwain
Death and Taxes – Institutional Investor – Preston McSwain
The Road Less Traveled – Simple Alternatives – FWP – Ryan Larson, CFA, CAIA and Preston McSwain
SPIVA After-Tax Scorecard – Dow Jones Indices
After-Tax Performance of Actively Managed Funds – Alpha Architect
The Road Less Traveled – Simple Alternatives 
Are Most Investment Managers One Hit Wonders? The Certain Drag on Performance – Taxes