Tax Planning Updates
By Selwyn Gerber:
Chapter 7: THERE’S A HOLE IN THE BUCKET: WHY ACTIVE INVESTORS GET LOUSY RETURNS
Most investors don’t realize how multiple layers of fees and tax inefficiency eat away at their portfolio returns. Active managers pursue gains without consideration of the best interests of their investors.
“If you pay the executives at Sarah Lee more, it doesn’t make the cheesecake less good. But with mutual funds, it comes directly out of the batter.”
- Don Phillips, President, Morningstar
Mutual funds are managed by some of the best and brightest minds on Wall Street. The managers have the best of intentions and are sincerely motivated to deliver the best returns possible. Unfortunately, not all of them can be better than average and most can not even overcome the handicap imposed by high cost structures to match the market.
When discussing the virtues of mutual fund investing, your investment advisor is very likely to bring up the miracle of compounding. You will be shown the value of investing for the long-term and how important it is to let you money work for you. These points have been illustrated in this book as well. However, most investment advisors leave out the rest of the story – what John Bogle refers to as the ‘tyranny of compounding costs’ which means that fees and taxes accumulated over long periods significantly reduce your wealth.
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One seemingly small cost is the amount managers spend to but and sell the thousands of shares of stocks they trade every day. These transaction costs add up over time. We all know from television and newspaper ads that stock commissions amount to only pennies a share. Mutual funds buy and sell a lot of shares and those pennies add up. While each transaction cost seems insignificant by itself, over time, they detract from the performance of the fund.
Morningstar studied this problem and found that the average turnover ratio for managed domestic stock funds is 130%. That means the manager is trading $1.30 for every dollar invested in the fund, implying that the average fund holds a stock for about nine months. All that trading costs money. The Bogle Financial Markets Research Center also looked at average mutual funds with an eye towards figuring out what all this meant to the average investor. They found that hyperactive trading resulted in annualized returns being lowered by about 0.7%.
Sacrificing less than 1% per year seems small, but over 25 years it will reduce your wealth by more than 15%. This idea is shown in Figure 8-1. A $10,000 investment grows to more than $108,000 with an average annual return of 10%, but slightly more than $92,000 at 9.3%. The difference of nearly $16,000 is the impact of trading costs.
Source: RVW Research
Figure 7-1: Small costs add up over time. Paying less than 1% a year in commissions can reduce your total profits by more than 15% over 25 years.
There is also an opportunity cost since very few stocks are likely to reach their full potential in less than a year. While always seeking next month’s winner, funds are often selling stocks that would be big gainers over time. They may buy back stocks they previously sold, but usually after missing out on gains and certainly after incurring trading costs. This is another reason to avoid active managers in favor of index investment strategies.
The full impact of the tyranny of compounding was illustrated by Bogle in The Little Book of Common Sense Investing. In his example, he assumes that the stock market will deliver an annual return of 8% over fifty years. An actively managed mutual fund will lag that by the cost of expenses, which he assumes to be 2.5% per year. Investing in the market will result in a $10,000 investment growing to $469,000, while the fund with returns of only 5.5% per year will grow to only $145,400. The difference, an astounding $323,600 is the cost of active management. Figure 8-2 shows that after two decades, an investor receives only 79% of the market returns. After 50 years, only 31% of the possible returns have accrued to the investor.
“When active managers boast their returns, savvy investors ought to deduct around 2% to determine a comparable return when reviewing their passive index based portfolios”
- Rip Van Winkle Wisdom
Source: Bogle Financial Markets Research Center
Figure 7-2: Total returns drop off dramatically with each decade. The average expenses associated with an actively managed mutual fund can reduce your returns dramatically over time, when compared to a passive, index-based investment approach.
An unseen cost is associated with taxes. SmartMoney calculated that because of capital gains and other tax distributions, mutual fund investors would pay over $32 billion in taxes for 2007 without selling a share. Because these gains are distributed to all holders, the buy and hold investor often faces a hefty tax bill in good years and bad ones. Actual performance has nothing to do with distributions, since they are based on tax accounting rather than the posted returns. The magazine calculated that the average investor loses 2.3% per year to taxes in an April 2008 article, “The Worst Kind of Surprise - A Tax Hit.”
When you add it all up, average fees account for a large part of the underperformance of actively managed mutual funds. Burton G. Malkiel, author of A Random Walk Down Wall Street, has noted that “… funds have underperformed benchmark portfolios both after management fees and even gross of expenses.” Whiles fees explain part of the underperformance, poor stock selection accounts for the rest.
Malkiel summed up the question of mutual fund fees with a single sentence, “The data do not give one much confidence that investors get their money’s worth from investment advisory expenditures.”
