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. The effect reinforces the substantial value of passively buying and holding stocks in an index fund.

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 these flawed strategies have on fund performance. Realized capital gains taxes are rarely highlighted in active mutual fund performance ratings, thereby catching the average active mutual fund investor by surprise when they prepare their tax return.

Let's review the case of 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 more than half the tax rate of short-term capital gains or dividends.

Another example of shareholders being hit with a surprise taxable event can be seen in Fidelity Magellan’s $22.36 per share (18% of total share value) distribution in May 2006. This unexpected and large capital gains distribution, which was prompted by a massive change (style drift) in Magellan’s stock holdings, caused an unnecessary and sizeable tax burden on the fund’s shareholders.

Taxes do Matter

Instead of being distributed and taxed, unrealized capital gains are gains that have not yet been realized for tax purposes. Unrealized capital gains remain a growing part of the net asset value of a fund, rather than being distributed to the investor. The index fund manager minimizes portfolio turnover, and so maximizes unrealized capital gains. 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 taxable gains and investors pay most likely short term capital gains taxes on those distributions. On the other hand, by the time an investor is ready to realize an investment gain in an index fund, it will most likely be a long-term capital gain, which has compounded many years in their portfolio.

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.

The study also 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%! The higher the returns of an actively managed mutual funds, the higher the probability of creating short term capital gains tax liabilites.

Actively managed mutual fund advertisements and published ratings feature pre-tax returns, often misleading investors. Only in the very fine print will you see mention of after tax returns. In fact, Robert Jeffrey and Robert Arnott showed in their 10-year study titled “Is Your Alpha Big Enough to Cover its Taxes?” that on an after-tax basis, and adjusted for fund loads or commissions, a simple low-cost and low tax S&P 500 index fund outperformed 97% of the active mutual funds in the study.

The primary reason passive investors pay taxes is to rebalance their portfolios, and this only makes sense because the benefits of maintaining of their target risk exposure level is worth the cost of the long term capital gains incurred from rebalancing.

So Uncle Sam is saying to active investors, "go ahead with your speculation; make my day." Passive rebalancers, on the other hand, avoid the uneccessary burden of high taxes and instead recognize that investors are compensated for bearing risk, not trading risk.