Note: This article appears on the ETFtrends.com Strategist Channel
By Chad Roope
One of the more basic and compelling advantages of cap weighted index investing is tax efficiency. Many portfolio managers today are trying to be too active with portfolio turnover, which may lead to higher tax bills and lower returns. This article will examine the tax ramifications imposed by an active, high portfolio turnover mutual fund relative to a strategic, cap weighted index mutual fund with low portfolio turnover.
While index mutual funds were used for this comparison due to longer track records, exchange traded funds (ETF) often have similar tax advantages. Due to the in-kind creation and redemption process of many ETFs, they possess inherent tax advantages over even index mutual funds. As the analysis will show, while Uncle Sam may be happy when investment managers turn portfolios several times in a given year, long term investors may not be quite as pleased.
Below are charts of two well-known mutual funds with long term track records. Both funds are classified by Morningstar as “Allocation—50% to 70% Equity”. One fund is an actively managed mutual fund and 3 Star rated by Morningstar. The other fund is a passively managed, cap weighted index fund and 3 Star rated by Morningstar. Both funds will approximate a “Balanced” allocation of 60% equity/40% fixed, however the active fund can vary significantly from these weightings whereas the index fund will maintain nearly exact weightings. The time period illustrated is from 01/01/1995 (earliest common data) to 04/30/2016 assuming no transaction fees or upfront loads or fees.
Performance has been somewhat similar, although the index fund has outperformed over the time period. The active fund has averaged approximately 200% annual portfolio turnover over the last 10 years (2006-2015), whereas the index fund averaged roughly 17% turnover over the same 10 years. Taxes, as shown, are assumed to be the highest marginal Federal bracket. State taxes are assumed to be 5% as state rates can vary significantly. Both scenarios assume $1,000,000 was invested in each fund on 01/01/1995.
As observed in Chart 1 for the active fund, the portfolio would have grown in value from $1,000,000 (average rate of 7.25%) to approximately $4,450,000 without accounting for tax ramifications. However, as shown in Chart 3, after factoring in taxes the portfolio value would been reduced to about $3,220,000. Taxes absorbed about $1,230,000 or 35.65% (taxes paid/pre-tax gain = $1,230,000/$3,450,000) of the gain with the active fund.
The index fund, as shown in Chart 2, would have grown from $1,000,000 to approximately $4,800,000 (average rate of 7.63%). Chart 4 illustrates the impact of taxes on the passive fund, which would have reduced the portfolio value to approximately $3,770,000 after paying for taxes. For the passive fund, taxes absorbed about $1,003,000 of the about $3,800,000 pre-tax gain, or 26.39% (taxes paid/pre-tax gain) of the gain.
The active fund produced less return and almost $230,000 more in tax ramifications. Many managers today produce higher turnover rates than the 200% the active fund in this analysis examined. Imagine how much more the tax bite would be with a manager who exhibits more than 400% turnover. This analysis illustrates how highly active, tactical managers may lead to higher tax bills, which is likely to make Uncle Sam happy. It also highlights how a strategic approach utilizing passive, indexing strategies may lead to higher returns and less taxes paid to Uncle Sam, which is likely to lead to happier investors.
This basic tax analysis exemplifies one reason why TOPS® portfolios are structured utilizing cap weighted, low cost index based ETFs. TOPS® portfolios are structured with the goal of offering investors the highest opportunities for long-term portfolio success. As examined, a strategic approach leading to lower portfolio turnover combined with low cost, tax efficient indexing may lead to better after-tax returns, which should likely benefit long-term investors.
Charts are for illustrative purposes only and do not reflect an actual client experience. ValMark Advisers, Inc. (“ValMark”) is a federally registered investment adviser located in Akron, Ohio. ValMark and its representatives are in compliance with the current registration and notice filing requirements imposed upon federally covered investment advisers by those states in which ValMark maintains clients. For registration or additional information about ValMark, including its services and fees, a copy of our Form ADV is available upon request by contacting ValMark at 1-800-765-5201. This article provides commentary on current economic and market conditions and is not directly relevant to any particular client account. The information contained herein should not be construed as personalized investment advice or recommendations to buy or sell any security. There can be no assurance that the views and opinions expressed in this article will come to pass. Investing involves the risk of loss, including the loss of principal. Past performance is no guarantee of future results. Information contained herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. Indexes are unmanaged and cannot be directly invested in. TOPS® is a registered trademark of ValMark Advisers, Inc. Diversification does not prevent or guarantee against loss.