Wealth Management

Clearing the Tax Hurdle to Beat Index Funds

By Paul Robertson, Tara Thompson Popernik, John McLaughlin April 27, 2015
Clearing the Tax Hurdle to Beat Index Funds

Many believe indexed mutual funds and exchange-traded funds (ETFs) are the best option for cost-conscious investors, particularly after taxes, but our recent research suggests that in practice, the tax advantage of passive investments is quite small.

After reviewing many academic and industry publications, we analyzed the claims that the very limited trading within indexed funds reduces tax costs, using both historical examples and our Capital Markets Engine forecasting tool. In our view, these claims are grounded in unrealistic assumptions that seldom apply to actual investors.

Our analysis suggests that, in the real world, tax-aware active managers need to clear a (post-fee) hurdle of about 0.17% over time to generate as much—or more—after tax-wealth as index funds, under our forecasts for median market conditions.. Why is the hurdle so low?

  • Active managers can dramatically reduce tax costs by limiting portfolio turnover and taking advantage of volatility;
  • In the real world, indexed funds generate significant realized gains, because most investors rebalance, withdraw money for spending, and liquidate their portfolios.

The Hurdle

Our analysis started with a hurdle rate of 3.14%, the annual premium after fees that we estimate a tax-insensitive active equity manager would need to match the returns of an equity index fund. This hurdle assumes annual portfolio turnover of 100% or higher (or an average holding period of more than a year) and that the investor will never spend from—indeed, will never touch—an all-equity portfolio for decades on end. That’s the blue bar in the Display.

Reducing portfolio turnover can help a lot. A tax-aware manager who reduces portfolio turnover to 33% (lengthening the average holding period to three years) would eliminate most short-gain gains. As a result, more than 2% of the starting hurdle would disappear, as shown in the Display by the green bar to the blue bar’s immediate right.

Volatility can be your friend. In the absence of taxes, volatility is simply a drag on performance. But active managers can harvest losses to offset current or future gains, reducing the tax drag for active managers. We estimate that would cut the hurdle to 0.78%.

Few taxable portfolios are static. Most investors balance their US stocks with international stocks, bonds, and other investments, and rebalance from time to time. Most investors also withdraw from their portfolios at some point to fund living expenses. These actions are likely to generate taxable capital gains for both indexed and active investors, and so reduce the tax advantage of passive portfolios relative to active portfolios. We estimate that they reduce the hurdle rate to less than half a percentage point.

Eventually, many portfolios are liquidated to support spending or pursue a new investment strategy; at that point, all the embedded capital-gains taxes come home to roost, indexed funds and active funds alike. And very high-net-worth investors who have no need to liquidate their portfolios during their lifetimes shouldn’t forget about the potentially heavy estate taxes their heirs may incur. Both capital-gains taxes from liquidation and the estate tax can take a big bite out of returns—bringing the active manager’s hurdle to just 0.17% after fees.

Indeed, an analysis of SEC-mandated returns reported by US mutual funds shows that the difference between pretax and after-tax 10-year returns for representative stock index funds and actively managed funds was virtually the same, after liquidation.*

Tax-aware active managers have an array of other strategies they can draw upon to reduce the hurdle rate even further, as we will discuss in our next blog post. For a full discussion of the topic, see our recently published white paper, “Clearing the Hurdle: Beating Index Funds After Taxes.”

*Periods ending either December 31, 2014, or December 31, 2013, depending on the availability of information. Index-fund universe comprises Vanguard 500, Mid-Cap, Extended Market, and Total Stock Market, and Schwab Total Stock Market; for actively managed funds, American Funds’ The Growth Fund of America, Dodge & Cox Stock Fund, Fidelity Contrafund, and AB Large-Cap Growth and Concentrated Growth.

Bernstein does not offer tax, legal, or accounting advice. In considering this material, you should discuss your individual circumstances with professionals in those areas before making any decisions.

Note on Bernstein Wealth Forecasting System

Bernstein Wealth Forecasting SystemSM is designed to assist investors in making long-term investment decisions regarding the allocation of investments among categories of financial assets. Our proprietary model, which uses our research and historical data to create a vast range of market returns, takes into account the linkages within and among the capital markets, as well as their unpredictability. Based on the assets invested pursuant to the stated asset allocation, 90% of the estimated ranges of returns and asset values the client could expect to experience are represented within the range established by the 5th and 95th percentiles; we often focus on the 50th percentile, or the median result. Asset-class projections used in this article reflect initial market conditions as of December 31, 2014. They include the following median forecasts of 20-year compound rates of return: US diversified stocks: 6.5%; municipal bonds: 2.8%.

Clearing the Tax Hurdle to Beat Index Funds
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