(From Dr. Derek Horstmeyer’s article in the Journal Reports: Funds & ETFs section of the Wall Street Journal on June 4, 2018. Click here for the original article. Dr. Horstmeyer is an assistant professor of finance at George Mason University’s Business School in Fairfax, Va. He can be reached at firstname.lastname@example.org.)
Some investors think that fees are always the difference. But it seems that some fund families are just better at managing tax issues than others.
Many investors believe that the best way to choose among similar index-tracking funds for long-term investment is to pick the one with the lowest fees. But there’s a better way: Compare the funds’ after-tax returns.
Looking at the 25 most popular S&P 500 index funds, measured by assets under management, it’s clear that the tax-management practices of the funds are more important to their long-run performance than their fees are.
It might seem that because index funds are meant to be passively managed, there shouldn’t be much distinction among them when it comes to portfolio turnover and other tax-management issues. While the buying and selling of securities in an active manager’s portfolio will surely affect the taxes paid on short-term and long-term capital gains—and affect long-term performance—how could tax issues be of significant concern for funds whose managers are simply tasked with following an index?
At first glance, they aren’t. When the 25 most popular S&P 500 index funds are ranked by their pretax performance over 10 years, the difference in average annual returns between the fund at the 75th percentile of performance and the fund at the 25th percentile of performance is 0.115 percentage point. That nearly matches the difference between those funds in operating expenses—passed on to investors as fees—of 0.10 percentage point (0.06% for the fund at the 75th percentile of performance versus 0.16% for the fund at the 25th percentile).
In other words, for pretax returns, all that appears to matter when deciding which index fund to go with is the fees that you will be paying the fund manager.
Where the gap is
However, a much bigger gap emerges when the funds are ranked by after-tax returns. After adjusting for the management fees paid at each fund, the difference in the average annual returns over 10 years of the fund at the 75th percentile of post-tax returns and the fund at the 25th percentile is 0.26 percentage point. This is a pure measure of the performance difference due to tax-management practices, since operating expenses and other fees have been negated in this calculation.
For the most part, differences in the after-tax performance of the 25 S&P 500 index funds were persistent over the entire decade. A fund that performed in the top half of the group for after-tax returns during the first five years of the sample period had a 72% chance of being in the top half of the group in the latter five years of the period. It seems that some funds are just better at managing tax issues than others.
The role of flows
What drives after-tax differences in returns among S&P 500 index funds? The biggest challenge to fund managers is largely out of their control: inflows and outflows of money from the funds. The greater the volatility in these flows, the more the fund manager has to rebalance—to keep the fund in line with the index it tracks—by buying or selling securities, which leads to a greater tax bill.
While the overall trend of inflows and outflows depends largely on the movements of the stock market—the greatest outflows, for instance, occur during times of market panics—the effect differs for each fund. And fund managers can distinguish themselves by how effectively they tackle this challenge. For instance, it’s possible for an index-fund manager who is attuned to the tax considerations of the fund’s portfolio to harvest some losses along the way—selling stocks that have fallen, to realize a tax-deductible loss—to reduce the future tax bill while minimizing the effect on the fund’s ability to track its benchmark index, says Rich Powers, head of ETF product management at Vanguard.
Other drivers of differences in after-tax returns are how managers handle rebalancing their portfolios around market-moving events like mergers and acquisitions, or around the occasional changes in the S&P 500 index.
In the end, the numbers make it clear: Taxes matter in passive investing, just as they do for actively managed funds.