What our research also found was that beating the benchmark is difficult for active managers, after considering fees, and even more difficult after considering taxes. Over the period 1982–1991, only 15 of 71 large active equity mutual fund managers outperformed the Vanguard 500 Index Fund (Jeffrey and Arnott, 1993). After taking capital gains tax and income tax on dividends into consideration, the number of outperforming managers dropped to 9. Investors and their advisors must remember that understanding how best to generate pre-tax alpha is critical, but success on that score is for naught if the impact of taxes is ignored or poorly managed.
What’s New Since 1993
Tax-advantaged investing is now a well-established part of the asset management business—although not nearly as large as it should be! Many techniques allow us to defer taxes with relatively little detriment to a fund’s pre-tax performance, but sadly they command only a small niche in an enormous industry. Some of these strategies are:
- Deferral of capital gains—deferring sales as along as possible to avoid realizing capital gains and triggering the related tax liability.
- Loss harvesting—selling assets whose market value is lower than their cost basis to realize a capital loss, which can offset realized gains on other assets at the present time or in the future.
- Lot selection—selecting a particular holding (or lot) of an asset with the cost basis that produces the best tax outcome, when a position in an asset is being reduced.
- Wash-sale management—coordinating among portfolio managers under a single administrator to transfer assets to avoid violating the wash-sale rules.1
- Holding-period management—choosing when to sell an asset to get the most favorable capital gains tax treatment.
- Yield management—selecting low-yield stocks because they incur lower taxes than high-yield stocks.
Today, tax-aware investing, as compared to the more aggressive forms of tax-advantaged investing, composes a much larger segment of the asset management arena. In tax-aware, as compared to the more aggressive forms of tax-advantaged investing, managers do not have a systematic process to objectively and aggressively manage the tax consequences of their investment decisions. As a result, these managers may capture some of the benefit of tax-advantaged investing, but prioritize the quest for an uncertain and all-too-often negative pre-tax alpha ahead of the quest for a predictable and manageable reduction in the drag associated with reliably negative tax alpha.
Over the last 25 years, three other notable and positive changes that impact taxable portfolios have taken place. First, advisors, consultants, and investors are all much more aware of the importance of seeking to maximize after-tax returns. Second, the introduction of exchange-traded funds (ETFs) and exchange-traded notes (and to a lesser extent long-dated swaps) now offer investors a powerful tool for tax efficiency. These structures are designed to allow the deferral of capital gains taxes—typically at lower long-term rates—until the investment vehicle is sold. Third, smart beta strategies, which offer very low turnover, large capacity, and a rebalancing alpha that seems robust, are charting a new path to after-tax alpha.
What Hasn’t Changed Since 1993
An analysis of the data over the last quarter-century highlights the fact that two things haven’t changed since 1993: persistent alpha is still fleeting, and active manager fees are still high. The evidence shows that the capitalization-weighted index is still hard to beat for most active managers. According to data from SPIVA® (S&P Dow Jones Indices Versus Active), over the 10-year horizon ending December 31, 2017, 82.4% of US large-cap funds underperformed the S&P 500 Index and 84.2% underperformed over the 5-year horizon ending December 31, 2017.
Manager fees, easily tracked and understood by investors, are still high at slightly over a 1.00% average expense ratio for actively managed funds (Arnott, Kalesnik, and Schuesler, 2018). Higher fund expenses, including, of course, manager fees, are associated with worse performance. In 2003, Jack Bogle wrote about the cost matters hypothesis as he called it, concluding that “whether markets are efficient or inefficient, investors as a group must fall short of the market return by the amount of the costs they incur.” Passive index funds were launched in large part to lower manager fees and, in practice, actually improved after-fee performance. Bogle (1997) found that passive managers, even after fees, performed as well as the top quintile of active managers.
In Arnott, Kalesnik, and Schuesler (2018), we compared the evolution of fund expense ratios for active, passive, and smart beta funds over the period from January 2007 through December 2016. Where the costs were already low, the fee pressure has been higher—the average expense ratio for active funds declined 9% from 112 bps to 102 bps over the period, and the expense ratio for passive funds declined 15% from 46 bps to 39 bps.