The Taxman Cometh

  
A couple of years ago, Sprout was finishing up breakfast.  He was deep in thought.

Sprout: Poppa, why do women wear makeup?

Deadwood: Well, they are trying to make themselves look prettier.

Sprout: Poppa, men don't wear make up.

Deadwood: That's right.

Sprout: So women are uglier than men?

I had to think about that one.

Deadwood: Well, I've heard worse logic than that...

 

"Yo, Dampwig, how ya' doin'?"

Oh, hey there, Slash.  I'm fine.  How are you?

"I'm good.  I just made a major change to my investment portfolio."

Really?  Good for you!  Did you move all your money into index funds?

"Just the opposite.  I moved all of my assets out of them.  I am now 100% active management!"

Uh...okay.  Really?

"Don't go acting all shocked and dismayed.  I know you really like index funds, and even the Buffster and Chuckie almost had me convinced."

Then what happened?

"I met with my financial advisor over at Sachs & Lynch.  He used pure, ironclad logic to convince me that active management is the way to go.  And you know me, I'm nothing if not logical."

Do tell.

"Okay, listen up, Darkwedge.  This blows up your point of view like a cherry bomb in a pile of poop.  So here's what he said...Why do people get paid to work?"

Uh...because other people value the service they provide?

"Exactly.  I get paid for my work.  You got paid for your work.  And financial advisors get paid for their work, too.  So they must provide something of value.  Capital markets are too efficient to pay people for no value.  Capiche?"

Oh, I understand, I just disagree bec..

"Hold on there, Dipwhip, it's your turn to be patient with me.  Now, in contrast, index funds just return what the market returns.  It's as dumb an approach as possible.  There's no researching companies, no seeking high growth potential, no finding undervalued stock, no determining trending sectors, nothing like that.  And what kind of fee do you pay for that?"

Usually, very low fees.  I've seen as little as 0.04%.

"Right.  And that's because there's no value add.  Sachs & Lynch is charging me 1.25% because the company researches, and finds value, and trades, and monitors, and moves my money around.  The company does work, and I gladly pay for it, because they beat the market.  POW!  Just blew up your stink, Doomworld."

Okay, except that isn't right.  On average, actively managed portfolios merely match market returns before fees.

"What?  C'mon Deadwood!  How on earth can you possibly claim that?!"

Well, here's my logic.  Let's say every trader on Wall Street wears a yellow tie or a red tie.  If the average height of every trader is six feet, and the average height of those wearing yellow ties is six feet, then the average height of those wearing red ties must also be six feet.  Simple logic, right?

"Right..."

Same thing with investments.  If the overall market returns X%, and passive portfolios return X%, then active portfolios, on average, must also provide the market return of X%.  They don't beat the market on average.  They match it.  Just like index funds.

But here's the rub: Let's say your fees are typical and the average active portfolio also is charged a fee of 1.25% while the average passive portfolio is charged say, 0.25%.  That means, on average, the actively managed portfolio will under perform the passive portfolio net of fees by a full 1% a year.  Again, simple logic.

So, on average, your active portfolio will do quite worse than its index fund counterpart, Slash.

"Okay, wait.  Let me think about this...Okay, but maybe the 1.25% that Sachs & Lynch is charging me is worth it.  Because there's nothing to say I have to have market returns.  There is always the chance that I will outperform the average, whereas there's no chance of doing that with index funds.  Bam!"

That is true.  But the fee you pay for that chance isn't really an investment choice so much as a bet on red.  Only, worse odds.  Because not only do you have to overcome that colossal fee, you also have taxes chipping away at your earnings.

"What do you mean?  Whether active or passive, my capital gains are both subject to taxes."

Unfortunately, how a portfolio is managed drives big differences in when those taxes occur.  Active portfolios typically have 100% - 200% turnover of their positions in a given year.  Why?  Because active managers buy, sell, time the market, shift their asset allocation, etc. all in an attempt to "add value."  Index funds are closer to 0% turnover, because their only goal is to match the market.  Not much work, as you yourself said.  As a result, the realization of capital gains is quite different between active and passive.

Here's a hypothetical example:

Remember our friends, Rich Mann and Rock Bahtum?  Each of them invested $500 K and let it ride for 30 years.  Rich went passive.  Rock went active.  Now, amazingly, Rock is doing much better than average.  Rock's portfolio is actually able to cover the difference in fees between him and Rich year after year after year.  (This is highly unlikely, but I want to isolate the effect of taxes here.)  So Rock's strategy, while not yielding any better results than Rich's, at least isn't doing any worse.  Right?

"Right!"

Wrong.

"Doh!"

In this very simplified example, both Rich and Rock earn the same returns, but because Rock went active, he realizes all of his capital gains each year (100% turnover).  Rich, on the other hand, doesn't realize his capital gains until the end of the thirty year period.  The impact is that Rock's net worth is over a third less than Rich's.  And this is with the very optimistic assumption that Rock's portfolio is able to consistently cover his expenses enough to achieve the same returns as Rich.

"But why would it matter if Rock's capital gains are realized each year instead of at the end of the thirty year period like Rich's?"

Because the money that Rock has to pull out to pay his taxes is no longer generating additional returns for him.  Rich gets to compound everything, Rock's portfolio only compounds net of annual taxes.  Small differences compound into huge deltas over time.

 

Go passive and delay taxes.

 

"(Sigh.)  So what are you telling me, Dankwell?"

Have another talk with your financial advisor.  Or just drop him all together.  Your choice.
 

"I hate you."

I know.

Sprout: Poppa, women wear perfume, too.  But men don't.

Deadwood: Yeah, we probably shouldn't go there.