Warren Buffett put his investment strategy this way in his 1996 letter to shareholders: “We continue to make more money when snoring than when active . . . Inactivity strikes us as intelligent behaviour.”
The world’s most successful investor was talking about the art of investing in public companies. But the observation could just as easily have been about investing for higher after-tax returns.
That is because short-term gains – generated from assets held for a year or less – are taxed at a higher rate than those from assets held more than a year. Lots of activity can mean a high tax bill, unless a tax-savvy manager looks for ways to offset those gains with losses.
“One of the fastest ways to destroy wealth is to react to everything,” says Christopher Wolfe, chief investment officer for Merrill Lynch’s private banking and investment group. “One of the goals we seek to achieve as advisers is to protect and grow the real after-tax value of clients’ capital.”
Managing a portfolio tax-efficiently is one thing. Systematically reporting returns on an after-tax basis is another. For now, Merrill is not going down that road.
“The tax code is very complex and historically tax rates have not been stable,” Mr Wolfe says. “One outgrowth of that problem is a liability for reporting incorrect data; another is the tremendous administrative burden that accrues when clients have complex portfolios.”
Those challenges have not stopped Veritable, an independent multi-family office near Philadelphia with more than $8bn of assets under management. It has provided after-tax reporting since 1986.
“If you don’t know how a tax-paying client is performing after tax, you don’t know how they are performing,” says Michael Stolper, a general partner at Veritable. “You rarely hear anyone speak about after-tax returns and you never hear about after-tax mandates, both of which are central to how we approach investing.”
He believes this approach provides clients with “a true accounting of performance and a clear understanding of the amount of money they have made”, adding: “After-tax reporting may expose the fact that gross performance, although sometimes impressive, may overstate the . . . return the investor was able to keep.”
After all, a 10 per cent return is not really a 10 per cent return if an investor has to pay 35 per cent of it to the federal government. (For most investors, gains on stocks, bonds and mutual funds held more than a year are taxed at a maximum federal long-term capital gains rate of 15 per cent. Short-term gains – on investments held for a year or less – are subject to ordinary federal income tax, which can be as high as 35 per cent.)
At Veritable, after-tax reporting is a labour-intensive process that ranges from vetting and monitoring money managers to making ongoing tax-efficient investment decisions and creating custom hypothetical indexes for every investment a client makes. It is not difficult to see why the industry has developed an institutional perspective focused on gross returns.
“The reason returns are not commonly reported on an after-tax basis is because there are no incentives for most money managers or mutual funds to do so,” Mr Stolper says. “There are no rewards for producing after-tax returns and no benchmark. Non-tax-paying institutions have dominated the public markets and so money managers and mutual funds have catered to that. It’s also very difficult to make comparisons of after-tax performance because every investor is unique and in order to track after-tax returns versus some index, you can’t just do a simple return analysis on the index; you have to go out and create a unique index for each investment and investor.”
Lipper estimates that during the past decade the taxman has shaved 1.4 to 2.3 percentage points annually from the total returns of taxable shareholders. According to Tom Roseen, senior research analyst at Lipper, mutual fund investors in taxable accounts paid $15bn in taxes in 2005 and $23.8bn last year. For 2007, the total bill could top $25bn.
One class of investments considered tax-efficient is index funds, which have low fees and lower turnover than actively managed mutual funds. And the lower the turnover the less likely the fund is to have short-term capital gain distributions.
“The decision to employ an active investment strategy should be based on whether that strategy has the ability to beat a passive index after fees and taxes,” says Mr Stolper. “In fact, the passive index is the benchmark against which all liquid investments should be measured.”
Tweedy, Browne, a private investment company and long-time advocate of investing for higher after-tax returns, put it this way in a report published in the late 1990s: “Anyone in the investment management business who does not respect the challenge of low-fee index funds that rarely sell stocks and, therefore, rarely realise capital gains is, as psychologists would say, in denial.”
Robert Wyckoff, a managing director at Tweedy, Browne, says investors should be more focused on after-tax returns. “Anecdotally speaking, I don’t think enough attention is paid to after-tax returns. Because a big part of the investing public is taxpayers, [after-tax returns] should really be the measure of success and very few money managers speak to it.”
He adds: “From our point of view, it is about keeping turnover at a reasonable to low level. You have to be willing to be a long-term investor. Over the long term, our portfolio turnover has been about 20 per cent a year or less; in recent years it has been lower than that. When you sell a security you have to pay the piper.”
But as Margie Carpenter, a portfolio manager at MAI Wealth Advisors, an independent wealth management firm in Cleveland, Ohio, points out: “Just because a [mutual fund] manager had a low turnover strategy in the past and says he will in future doesn’t always mean that will be the case. A lot of work has to be done behind the scenes to make sure the managers stick to low-turnover strategies in the future.”
Watching turnover is crucial. According to Morningstar, the average turnover ratio for all equity funds is 91 per cent, and 53 per cent for all equity index funds. (The average for actively managed equity funds only is 93 per cent.)
“The very high average portfolio turnover rates of professional mutual fund managers leads us to believe that very few professional investment managers carefully consider the effect of taxes on investment returns for tax-paying individuals,” notes the Tweedy, Browne report. “The typical money manager is not oriented toward owning businesses over any multi-year length of time through the stock market.”
Steve Persky, managing partner of Dalton Advisors, a private wealth manager, puts it more bluntly: “Actively managed mutual funds for taxable investors have a lot of critical flaws: first, they often have high turnover and pay capital gains distributions; and second, historically most actively managed mutual funds don’t outperform the indices. Actively managed funds don’t generate returns, are expensive, and incur capital gains taxes. Other than that they are perfect.”
So what does he advocate? “Exchange-traded funds are a quantum leap ahead of index funds because they don’t pay taxable capital gains dividends,” he says. “Using index funds and ETFs as the main components of a tax-efficient strategy typically implies less turnover than a strategy of investing in individual securities and/or actively managed funds. It is turnover that causes taxable gains, and taxable gains are a problem. Capital gains [taxes] and high fees are the enemies of after-tax returns.”
And as most investors know, it is not what you earn that counts, it is what you keep.