Tax-managed mutual funds may simply be closet indexers, and expensive faux trackers at that.
That’s according to a study of US 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 US$40bn segment of US 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% 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.
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 towards 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 colouring 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 US 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.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he 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)
