Why Taxes May Be the Most Important Issue You Address in Your Portfolio

Because dividend and realized capital gains distributions are subject to state, local and federal taxation, after-tax returns (for taxable accounts) are the only returns that matter. However, most individual investors focus on pre-tax returns. Focusing on pretax returns can lead to costly decisions.

One explanation for this behavior is that investors are unaware of just how devastating an impact taxes can have on returns. Another might be that they're subject to "mental accounting" -- returns earned go into one pocket, but the tax bill is paid from another pocket, and the two are never tied together.

The greater turnover of actively managed funds makes them tax inefficient relative to passively managed funds. And the academic literature provides us with a large body of evidence demonstrating that taxes are the biggest expense most investors face -- greater than management fees or commissions. In other words, the quest for pretax alpha can generate negative after-tax alpha.

For example, the 1993 study "Is Your Alpha Big Enough to Cover Its Taxes?" found that only 7 percent of funds studied over a 10-year period beat a passive alternative on an after-tax basis, compared to 21 percent winning on a pretax basis. They concluded: "The preponderance of evidence is so convincing we conclude that the typical approach of managing taxable portfolios as if they were tax-exempt is inherently irresponsible, even though doing so is the industry standard." Let's look at the findings of another major study on the subject.

The study "How Well Have Taxable Investors Been Served in the 1980s and 1990s?" investigated:

• The pretax and after-tax efficiency of actively managed funds
• The likelihood of pretax and after-tax outperformance
• The relative size of outperformance versus the relative size of underperformance

• The average fund underperformed its benchmark by 1.75 percent per year before taxes and by 2.58 percent on an after-tax basis.
• Just 22 percent of the funds beat their benchmark on a pretax basis. The average outperformance was 1.4 percent, with the average underperformance being 2.6 percent. However, on an after-tax basis, just 14 percent of the funds outperformed. The average after-tax outperformance was 1.3 percent, while the average after-tax underperformance was 3.2 percent. The risk-adjusted odds against outperformance are about 17:1.

This study was updated in 2011 and concluded that the typical approach for managing taxable portfolios - acting as if taxes cannot be reduced or deferred -- remains the industry standard. Yet, the authors estimated that the typical active fund needs to generate a pretax alpha of more than 2 percent per year to offset the tax drag resulting from their active strategies -- and most can't accomplish that feat. The finding of a tax drag in excess of 2 percent is consistent with the findings from other studies.

It's important to consider that because of the two bear markets we experienced in the first decade of this century, the impact of taxes on returns has been less than what many investors have experienced long term. That's why it's important to look at data from prior periods.

The evidence is so overwhelming that Ted Aronson, an institutional fund manager with about $20 billion of assets under management, offered this advice: "Once you introduce taxes active management probably has an insurmountable hurdle."
Given the evidence, it's not surprising that most fund managers focus on pretax returns. However, ignoring the impact of taxes on the returns of taxable accounts is one of the biggest mistakes you can make. You can avoid this mistake if you keep the following points in mind:

• Because of the important impact on returns, passively managed tax-managed funds should be the investment vehicles of choice for taxable accounts.
• Exchange-traded funds are also appropriate vehicles, as their structure generally enables them to be highly tax efficient.
• If you do use actively managed funds, they're best held in tax-deferred accounts, where their tax inefficiency won't impact after-tax returns.

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