That’s according to a study of U.S. equity mutual funds classified
as tax-managed, meaning they attempt to add value by both active
management and keeping taxes at bay.
“They don’t really do all that much better in terms of being tax
efficient,” said David Nanigian, of The American College and
co-author of the study with Dale Domian of York University and
Philip Gibson at Winthrop University.
“Even when the tax burden is lower, the incremental expenses charged
by these funds above and beyond passive counterparts vastly exceed
any incremental tax savings that they offered.”
The arrival in early 2016 of tax forms will underscore once again
the advantages of minimizing tax on investment. That’s led to the
advent of a $40 billion segment of U.S. equity mutual funds
classified as tax-managed.
According to the study, published in the Fall edition of the Journal
of Wealth Management, the early results are not encouraging.
The study looked at performance among tax-managed funds from 2010 to
2014, comparing them with actively managed peers, passive mutual
funds and passive exchange-traded funds.
While those years may be anomalous in some way, the study found that
more than 95 percent of the variability in the returns in
tax-managed equity funds is explained by common factors in stock
returns, a number that the study says highlights “lack of effort in
security selection.”
That’s another way of saying that these funds look suspiciously like
closet indexers, mutual funds which hug the index, taking only
relatively small bets on speculations they hope will generate
outperformance.
Closet indexing may be a smart move for fund mangers, minimizing
career risk, but investors end up paying quite a bit more for a
product which may not be too different from a cheaply available
index fund alternative.
“Tax-managed funds appear to follow the simple index-tracking
strategies pursued by passively managed funds, yet they cost two to
three times as much,” the authors wrote in the study.
TOTAL MARKET FOR THE WIN
Expenses of tax-managed funds were statistically indistinguishable
from those of their actively managed counterparts. Yet when you
compare results, the tax-managed funds fail to save enough on taxes
to outweigh their extra expenses when compared with passive funds.
There are primarily three ways in which you can manage a fund with
taxes in mind. One is to minimize dividends, which pay tax at a
higher rate than capital gains, second by tax-loss harvesting, which
means selling winners paired with losers where possible to offset
taxes, and third by avoiding short-term trading and the higher taxes
charged on capital gains for assets held less than one year.
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While the study does not indicate one way or another, it may simply
be too difficult to generate enough value through those methods to
make up for the extra cost as compared to a passive investment.
“It’s possible but not likely,” Nanigian said. “We don’t notice a
trend toward improvement over time.”
That rather points to the alternative explanation: that calling
oneself tax-managed is often essentially more marketing than
reality, as funds seek to adopt protective coloring that will allow
them to earn higher fees amid fierce competition.
Based on a reading of the study, investors wanting to minimize tax
would do well to choose total market index funds, ones that track a
very broad index of U.S. equities such as the Wilshire 5000.
Index funds have a tax advantage as they don’t buy or sell unless a
share enters or leaves a given index, reducing the occasions which
might generate a capital gain. The broader the index tracked, the
less turnover you will get, something that keeps a lid not just on
expenses but on tax. Over the study period the mean tax burdens of
total market index funds ranged from 0.407 to 0.521 percentage
point, well below the 0.518 to 1.247 in mean tax borne by the
broader group of index funds.
To be sure, the study covered only a few years, years with generally
good stock market returns and low volatility. It may be that
tax-managed funds do better in a choppier market, something we may
well see as interest rates rise in the coming year.
Possible, but based on the data thus far, not a bet most investors
will want to make.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be an
owner indirectly as an investor in a fund. You can email him at
jamessaft@jamessaft.com and find more columns at http://blogs.reuters.com/james-saft)
(Editing by James Dalgleish)
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