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Passive vs. Active Management – Tax Effect

In doing some research into active management funds and passive (indexed) funds, which I will be writing more about later, a topic came up about how some studies overlook the effect of taxes on certain investment styles (e.g. buy and hold versus active management). Thus, let’s take a quick look at a simple analysis of how taxes can adversely affect the returns of a fund that has a lot of turnover in any one year.

To see this mathematically, let’s assume a 10 year holding period and a 10% annual return with a 20% tax rate (15% capital gains and 5% state tax):

Buy & Hold return

= (1 + 10% return) ^ (10 years) – 1 = 159% return

= 159 * (1 – 20% tax rate)

= 127% return after-tax

Annual Turnover

For simplicity, let’s assume a 100% turnover a year in stocks held at the end of each year. Many funds do not turnover this much; however, some turnover also causes greater short-term gains that are taxed at a higher tax rate than 15% capital gains which would lower the return.

Return with turnover = (1 + 10% * (1 – 20% tax rate)) ^ 10 years – 1

= (1.08 ^ 10 – 1) = 116% after-tax return

So you can see that a buy and hold strategy produces a significant return compared to an actively managed portfolio assuming that each has a comparable return (e.g., 10%) pre-tax. Yet, a reason that people select an actively managed account is due a belief (whether it is true or not is subject to debate) that a manager/broker can outperform the market. In this example, the average return for the active managed fund needs to be 10.7% return instead of 10% return to overcome the adverse tax effects. This may not be a large difference, yet when you add the additional fees paid for managers (1% to 2%), the differences start to add up.

Note, the effect of taxes may be more or less depending on the holding period, how often a portfolio is turned over (bought and sold), how turnover results in short-term capital gains (taxed at higher rates than capital gains) and the taxation by your state on investment gains/losses. There would be also taxes paid on an indexed fund due to some turnover (usually minimal to match index) and dividends. Thus, always review the funds perspective for turnover, short-term vs. long-term capital gains and expenses to determine which fund is right for you.