Tax-Savvy Choices for Equity Investors
When you’re building portfolios and evaluating performance, it’s easy to think in terms of pre-tax returns. But in reality, it’s the after-tax returns that matter for taxable investors.
Tax efficiency is important, but it isn't everything
There are a variety of different characteristics to weigh when selecting a strategy and vehicle for your equity exposure. For example, active equity open-end mutual funds (OEFs) seek to outperform an index, which comes with the cost of lower tax efficiency. Conversely, index exchange-traded funds (ETFs) seek to track the performance of an index, which generally lends to higher tax efficiency.
Tax-managed separately managed accounts (SMAs) focus on adding to after-tax returns by seeking to generate tax losses that offset taxable gains from other assets in the portfolio – a practice known as creating “tax alpha.” Some tax-managed SMAs may also seek to outperform an index.
Why does tax efficiency differ across investments?
The answer comes down to vehicle structure and strategy. An OEF may trade frequently in its pursuit of outperformance and may also be forced into tax-inducing trades due to shareholder redemptions. On the other hand, a traditional capitalization-weighted index ETF tends to trade a lot less, which helps to minimize taxable events within the fund that lead to capital gain distributions.
While both OEFs and ETFs can reduce the impact of taxes by selling their underperforming securities at a loss near year end, tax-managed SMAs are better equipped to manage tax costs throughout the year.
How can buy-and-hold investors quantify tax efficiency?
When you sell a position in a taxable account, you pay tax on the realized gain regardless of the type of investment. However, even as a buy-and-hold investor, you will also pay taxes on any dividends or capital gains distributed to you (typically quarterly or annually) during the time you held the investment. This “tax drag” can vary materially between investment vehicles.
Tax drag typically does not occur in a tax-managed SMA given its focus on generating tax alpha. Among registered fund products on average, OEFs have historically had the highest level of tax drag, while ETFs have had the lowest.1
When considering an OEF for a taxable account, investors should evaluate whether the expected level of above-benchmark returns would sufficiently offset the tax drag. If not, the OEF may still be an appropriate investment for a tax-exempt or tax-deferred account, where tax drag is irrelevant.
Just like performance, it isn’t possible to know exactly what an investment’s tax drag will be ahead of time. However, it can be reasonably estimated based on the investment’s historical averages and the investor’s individual tax rate.
The bottom line
We’ve intentionally focused this discussion on equities through the lens of active OEFs, index ETFs and tax-managed SMAs to illustrate the trade-offs in investment solutions most commonly used today. But we note that the evolution of the investment industry has introduced nuances such as active ETFs, in which investor interest is growing. And while index ETFs have made their way to the mainstream, index OEFs continue to hold a meaningful place in portfolios.
Tax-aware strategy and vehicle selection play a critical role in protecting and building wealth. While individual situations vary, the tax efficiency of investments should always be considered alongside potential outperformance, risk, liquidity, fees and other considerations.