Updated February 2021

TAX EFFICIENCY AND PASSIVE AND INDEX INVESTING

Abstract:  Passive and index portfolios reduce the pass through of capital gains through inherently low turnover rates of securities within portfolios.  They can also reduce taxes on dividends through selection of lower yielding dividend paying equities in a given asset class.  Within passive and index portfolios low turnover rates also mean transaction costs and other expenses are reduced for investors.  Over long time frames these reductions increase after tax returns to passive investors significantly.  Annual pass through of capital gains in DFA equity funds typically runs 1% to 2% per year and DFA offers several tax managed and tax advantaged funds which reduce pass throughs even further.

Passive and index investment strategies produce lower capital gains and dividend pass throughs in taxable accounts when compared with active funds.  Active managers frequently trade stocks or bonds and "turn over" securities in portfolios far more rapidly than passive and index managers.  Consequently, investors in actively managed funds or portfolios will realize higher capital gains taxes than passive and index investors.  Though there is wide variation, average actively managed portfolios have turnover rates of roughly 15% to 50% per year while it is around 1% to 2% in passive and index portfolios.  There is substantial yearly variation in capital gains depending upon market returns.  For many asset classes and many years DFA's pass through of capital gains has run around 0% to 2% of the net asset value (NAV) for most of its funds.  DFA also offers many funds which are tax managed internally to reduce capital gains and dividend taxes.

Several studies have examined the deleterious effect of high turnover rates on after-tax portfolio returns.  Their effect is substantial.  A Stanford study compared median pre-tax and after-tax performance for 62 actively managed stock mutual funds over a 30 year period from 1963 through 1992.  A high tax bracket investor received less than half of the pre-tax performance, 45%, and a medium tax-bracket investor, 59%, due to tax pass throughs.  Further, assuming investors cashed out at the end of 30 years they would pay further capital gains upon liquidation and capture only 42% and 55% of the pre-tax return respectively due to pass-throughs.  Over even short time frames the effects of high turnover and capital gains taxes on returns is still substantial.  Morningstar looked at returns for actively managed U.S. equity funds for 1992 through 1996.  Investors with the highest Federal capital gains tax rates received on average a little over 70% of the total returns they would have received had their money been invested in a tax-deferred account.  Wall Street and mutual funds report performance figures before taxes and liquidation.  In fact, mutual fund managers are frequently hired or fired by firms and by clients naively comparing their absolute performance with other managers while tax consequences and real after-tax returns are ignored.  A study by David Booth of DFA compared the after-tax performance of two stellar active funds, Janus and Fidelity Magellan, for a 15 year period ending in 2000.  Both funds outperformed the S & P by 2% annually but, after taxes trailed it by 0.4%.  Tax-efficiency matters and passive and index portfolios maximize it.

Another study published in 1993 looked at the pre-tax and after-tax performance of 72 funds classified by Morningstar as large growth or growth and income.  Their analysis included funds in existence for the 10 year period from 1982 through 1991 and included the Vanguard S & P 500 index.  On a pre-tax basis the Vanguard index outperformed 79% of the actively managed funds.  On an after-tax basis, it outperformed 86% of the active funds.  When mutual fund expenses were added only 2 of the 71 funds, 2.8%, outperformed the S&P 500 after taxes.  Investors with equity assets in taxable accounts will benefit significantly from using passive and index portfolios as opposed to actively managed and traded portfolios.  Capital gains tax pass throughs and tax-efficiency will vary from year to year in both active and passive portfolios since returns and gains and losses will vary.

DFA offers five tax-managed passive equity funds in discrete asset classes (one asset class per fund) as well as core/vector funds holding multiple asset classes.  Core/vector portfolios reduce turnover even further since they allow asset classes to drift within one fund rather than forcing sales when an equity drifts out of its asset class as is the case for discrete funds.  In addition DFA offers tax-managed versions of two core/vector funds.  In 2009 the majority of DFA's equity funds passed through no capital gains taxes because there were few gains to be had.  DFA's tax-advantaged and tax-managed funds reduce dividend pass throughs by about a third by weeding out high dividend payers in a given asset class.  Aside from using tax-managed funds investors can employ other strategies to minimize taxes in taxable accounts.  Fixed income allocations can be filled in laddered portfolios of municipal bonds purchased at par or premium which are then held until maturity.  No taxes will be due unless bonds were purchased at a discount.  And, equity asset classes with potentially high capital gains or dividend income can be placed in various tax-deferred accounts.

Some advisory firms promote tax-loss harvesting.  We examine tax loss harvesting elsewhere on our website in "Tax Loss Harvesting".  We do not promote the practice but will tax loss harvest whenever a client wishes to do so.  Tax loss harvesting involves buying or selling funds to realize losses then using those loses to offset pass through gains in funds which have produced them or gains from funds which have been sold.  Tax loss harvesting increases transaction costs and may reduce as well as augment after tax returns.

Tax-management strategies in active or passive portfolios rely primarily upon controlling the realization of capital gains and minimizing the pass through of dividends.  Retrospective statistical data promoting the advantage of tax-managed funds generally assumes higher levels of capital gains and dividends which occurred in the past and may not occur as strongly in the future.  Historical data indicates that for very long time frames the majority of returns in equities came from dividends, around 4.5% on average, and not from capital gains.  Should capital gains diminish or disappear in a protracted bear market the advantage of tax management would be diminished.  There is evidence for this in fund data during the 2000 through 2002 bear market and the 2008 financial crisis.  Delaying capital gains for ten or twenty years may mean that gains might be realized at a future time when capital gains are higher than today.  Capital gains taxes are relatively low in 2021.

What pass through of capital gains taxes might an investor expect to pay in a well-diversified passive and index portfolio with tax efficient equity funds?  Assuming that the few equity asset classes with high tax pass throughs of capital gains can be held in tax-qualified retirement accounts or a no-load annuity a rough estimate might be that about 1% in capital gains might be passed through by tax efficient DFA funds in the average year.  This would be taxed at 20% for most investors plus State capital gains taxes if applicable.  Thus, a modest 20% of 1% or 0.2% would be taxed or $200 on $100,000 in equity value plus whatever taxes are due from State capital gains.  As of 2021 average DFA dividend yields were historically very low, around 1.7% in the US and 3.5% overseas for most equity asset classes.  With dividends currently taxed at the same rate as capital gains then a $100,000 portfolio might pass-through $2000 annually in dividends resulting in an additional Federal tax on capital gains of $400 to $600 annually on a $100,000 equity portfolio if total capital gains and dividends are included.  On a few occasions tax-managed funds have passed through 8% or more in capital gains for a year.  Overall, passive and index strategies are very tax efficient versus active funds whether they are in normal or tax-managed form.