7.2.1 Silent Partners

There are numerous silent partners that take a bite out of realized and unrealized gains on investments. These partners include:

1. The sales agent or stock broker who earns a commission or load for individual stock and mutual fund trades
2. Federal and state income tax agencies that tax realized gains
3. The fund manager who actively invests the stocks in a mutual fund
4. Accountants
5. Firms that charge investment advisory fees
6. Market makers who earn a bid-ask spread on transactions
7. Transfer agents who handle the share transfers for all those trades
8. Mutual fund distributors
9. If applicable, the brokerage firm that earns interest on margin accounts

7.3.1 Active Investors are Unaware of all the Costs

Each partner's bite adds up to claim a significant share of an investor’s return. The tax effects on actively managed mutual funds are rarely evident from the reported data. Since investors do not feel the tax bite until the following April 15th, most investors do not consider more than 17% of their pre-tax returns as lost to taxes. The effect reinforces the substantial value of passively buying and holding stocks in an index fund. Table 7-1 demonstrates that on an after tax basis, the S&P 500 index fund outperformed both funds that routinely claim superior performance.

Table 7-1

According to a study conducted by John Bogle over a sixteen-year period, investors only get to keep 47% of the cumulative return of the average actively managed mutual fund, but they keep 87% in a market index fund. This means $10,000 invested in the index fund grew to $90,000 vs. $49,000 in the average actively managed stock mutual fund. That is a 40% gain from the reduction of silent partners....everyone should take that! See Figure 7-1.

Figure 7-1

Table 7-2

7.3.2 Taxes

Now let’s take a look at how the tax-managed index funds can almost eliminate Uncle Sam’s big bite out of your returns in taxable accounts. No wonder he looks so sad.

As indicated above, most index funds are very tax efficient. However, some indexes can be further tax managed to squeeze out even more taxes. Tax-managed index funds make an already tax efficient investment even more tax efficient by offsetting realized gains with a realized loss then deferring the realization of net capital gains and minimizing the receipt of dividend income. The result is minimal taxable distributions to investors.

See the results for year 2007 in this Schedule of Distributions.

In a telephone survey by the Dreyfus Corporation, one thousand mutual fund investors were questioned about their tax knowledge. Eighty-five percent of respondents claimed taxes play an important role in investment decisions, but only 33% felt that they were knowledgeable about the tax implications of investing. Eighty-two percent were unable to identify the maximum rate for long-term capital gains.

Table 7-3

Taxes on realized (distributed) capital gains, dividends, and interest can be significant. It is estimated that the average active mutual fund investor loses about three percentage points of return to taxes every year. The more an investor earns in active mutual funds, the higher the taxes. This reduces the potential for wealth, which defeats the purpose of investing. A study conducted by Stanford University measured the performance of 62 equity funds for the period from 1963 through 1992. It found that although each dollar invested in this group of funds would have grown to $21.89 in a tax-deferred account, the same amount of money invested in a taxable account would have produced only $9.87 for a high-tax-bracket investor. Taxes cut returns by 57.5%! Index funds, however, have low portfolio turnover and their capital gains distributions are also very low, thereby reducing the impact of taxes. See Table 7-3.

Managers of Active Funds Seem to Manage Money as if Taxes do not Matter

Historically, many active mutual fund managers managed pension plans and other tax-free pools of money, so they did not have to worry about the tax impact of their investment trades. As a result, managers of active funds today often disregard the high taxes generated by their stock picks and market timing, not to mention the adverse effect on fund performance. Realized capital gains taxes are not reflected in active mutual fund performance ratings thereby catching the average active mutual fund investor by surprise.

Imagine an active fund, such as Invesco’s Asian Growth Fund. At the end of 1997, this company distributed 21% of its net asset value, but lost over 38% throughout the year. An investment of $10,000 at the beginning of 1997 lost $3,800 before the $2,100 gain on which taxes must be paid. Realized capital gains can be taxed in two ways: long-term (12 months or longer) capital gains or short-term dividends. The federal tax code ensures that long-term capital gains are taxed at nearly half the tax rate of short-term dividends whose maximum taxes are about 40%!

Taxes do Matter

Instead of being distributed and taxed, unrealized capital gains are profits that have not yet been realized for tax purposes; taxes need not be paid on these gains. Unrealized capital gains remain a growing part of the net asset value of a fund’s share rather than being distributed to the investor. The index fund manager minimizes portfolio turnover, and so maximizes unrealized capital gain. When stocks in an active fund increase in value and are sold for a profit by the fund’s manager, the result is that the fund actually realizes gains as opposed to simply reporting an increase in the value of the portfolio, and investors pay both ordinary income and capital gains taxes on those distributions. On the other hand, by the time an investor is ready to realize an investment in an index fund, it will be a long-term capital gain, untaxed for years. Realized long-term capital gains have a much lower tax rate.

As might be expected, taxes affect active fund performance, not only earnings. Stanford University released the results of a 30-year study in 1993 that examined the difference between the average pre-tax, after-tax, and liquidation performance of 62 actively managed stock mutual funds. Pre-tax performance assumes reinvestment of all distributions, after-tax assumes reinvestment of distributions left after taxes have been paid, and liquidation is selling out completely and paying all taxes, rather than reinvesting in the fund. The study also took into account differing tax brackets, whether high (55% taxes paid), medium (41%) or low (25%). According to the study’s results, between 1963 and 1992 it was found that a high tax bracket investor who reinvested after-tax distributions ended up with an accumulated wealth of 45% of the fund’s published performance. Investors in a middle tax bracket realized 55% of published performance.

As mentioned earlier, actively managed mutual fund advertisements and published ratings feature only pre-tax returns, often misleading investors. In fact, Robert Jeffrey and Robert Arnott proved with their 10-year study titled “Is Your Alpha Big Enough to Cover its Taxes?” that on an after-tax basis, index funds outperformed 97% of active mutual funds. They also found that although 71 active funds tried to beat the market with high turnover efforts, the added returns did not outweigh the resulting taxes.

7.3.3 Inflation

Unlike investment costs and taxes, nothing can be done about inflation.

Inflation is an equal opportunity destroyer of an investment’s purchasing power. A certain amount of loss from inflation is incurred whether an investment is in stocks or bonds, but investing as large a portion of a portfolio in stocks for as long as possible is the best way to outpace inflation. Stocks have grown in value much more than bonds over the years and have been the best antidote for inflation.

Inflation has averaged 2.7% per year over the last five years, which does not seem too significant. Therein lies the jeopardy! The investment media, politicians, and others may convince investors that a 2.7% inflation rate is insignificant, but this rate can cut purchasing power by 26% in 10 years, 45% within 20 years, and 59% within 30 years! A 2.7% inflation rate is only negligible in very short terms; an investment purchased for $10,000 in 1970 would cost $26,094 in 2006, so it is best to buy as soon as possible and not touch that money until the last possible moment. Not even tax-deferred retirement plans can escape inflation, the most inevitable partner.