IRS: Investment Returns Sucker
By Robert Bray
A tapeworm is a parasite that can be ingested when you eat raw or undercooked meats. They attach themselves to your intestines, silently sucking nutrition meant for your body. At first, most people don’t notice them. They just take a little here and a little there and they don’t bother the host all that much.
Similar occurrences transpire within actively managed portfolios as silent partners, little by little, suck away investment returns.
These silent partners are the tapeworms of the investment world, extracting management fees, transfer costs, and taxes to grow fatter and happier. In addition, there are other silent partners that take a bite out of both realized and unrealized gains on investments, including:
- Sales agents and stock broker who earn commissions or sales loads for individual stock and mutual fund trades
- Federal and state income tax agencies that tax realized gains
- Active fund manager
- Accountants for investors and fund companies
- Firms that charge investment advisory fees
- Market makers who earn a bid-ask spread on transactions
- Transfer agents who handle the share transfers for all those trades
- Mutual fund distributors
- If applicable, the brokerage firm that earns interest on margin accounts
Given that tax day is still freshly in the rear view mirror, let’s focus on the biggest tapeworm, err…silent partner of them all: the IRS (also known as Investment Returns Sucker). How can you prevent them from taking a giant chunk out of your returns next year? One way is to minimize your realization of capital gains. Almost all of most active managers capital gains are short term capital gains. On the other hand, most of the gains of indexers are unrealized gains.
Is it just us, or does this giant tapeworm resemble a big G — as in Government? Clearly, Uncle Sam is sad to hear about the low taxes paid by indexers.
Now, obviously it’s nearly impossible to completely eliminate Uncle Sam from your returns, but you can certainly make sure to keep the him at bay.
In addition to already being highly tax efficient, index funds can be tax-managed, offering further protection from taxes. On top of that, shrewd financial advisors can provide further tax benefits by applying tax-management trading strategies, such as tax loss harvesting which is the process of selling off funds in down markets to capture large losses which can be offset against future and significant gains. Additionally, by minimizing turnover, index funds maximize unrealized capital gains, allowing returns to remain undisturbed and contribute to the growth of the fund.
A study by John Bogle covers the 25-year time period from 1980 through 2005 and reveals the benefits of compounding wealth as well as the tyranny of compounding costs. The results of the study are depicted below, showing the effects of costs and taxes on the growth of $10,000 for the average equity investor, the S&P 500 Index fund investor, and an investor of a small-value tilted, globally diversified IFA Index Portfolio 100. As you can see, $10,000 invested in the average managed equity fund for the 25-year time period would have grown to $108,347 before federal tax considerations, with post-tax results of just $71,727. Meanwhile, $10,000 invested in the S&P 500 Index fund would have grown to a much larger pre-tax sum of $181,758, with investors enjoying an after-federal tax ending value 222% greater than the average equity investor. Even better, globally diversified investors who tilted their full equity portfolio toward small and value in an IFA Index Portfolio 100 would carry similar risk to the S&P 500 Index, but with allocation would have enjoyed pre-tax ending wealth of $306,975 and an after-tax value of $213,555, three times that of the average equity investor and 34% higher than the S&P 500 Index fund investor. This chart illustrates the value of buy and hold versus buy and sell.
An IFA study using data from Morningstar shows the value lost to taxes for the top 15 funds with the highest net assets.
Taxes have an enormous impact on long-term wealth accumulation, even when kept at bay. So over time, a portfolio’s return will be eaten away as the silent partners get their fill. The longer one uses active managers and inefficient tax strategies, the fatter the silent partners become. It’s time for you to truly understand the tyranny of compounding costs and their erosive impact on the ability for you to achieve financial security. It’s time to cut off the care and feeding of the parasites that feast on your returns.