Intelligent Design

John McMillen | Portfolio Manager

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Tax-Efficient Investing in a Tax-Inefficient World

March 2010

Trying to guess what the politicians in Washington are going to do in the coming year is a nearly impossible task; however, one thing most observers agree on is that taxes are likely to be increased for affluent investors in the years ahead.

While we can’t yet know to what extent tax rates are going up, we do know investors will always be well served by structuring portfolios in the most tax-efficient manner possible. There are three essential ways this can be accomplished:

  1. Minimizing Trading
  2. Embracing Passive Investment Management
  3. Practicing Asset Location 

1. Minimizing Trading: Trading causes not only tax recognition, but may also cause the tax burden to increase if a short-term capital gain is realized. Many investors are under the misguided belief that activity is good because they, or their investment manager, are moving from investment to investment, seizing “opportunity” in the process. And many active managers secretly believe activity is good because it helps them look busy, which helps justify their high fees.

The reality however, is that frequent trading doesn’t add value – it actually drags on performance. This is attributable to the fact that the new position purchased must not only generate at least the same return as the old position, but must also earn a premium to compensate for the incurred trading cost (commissions and bid/ask spreads) and the newly created tax liability. When this burden is multiplied among hundreds or even thousands of trades in a portfolio over a number of years, it is unlikely any investor or manager will be able to recoup these additional costs on a consistent enough basis to justify active trading as a strategy. This is why most active managers fail to beat their passively managed benchmark.

2. Embracing Passive Investment Management: The second rule, which is a close cousin to the first, is to hold only passively managed investments. Passively managed funds experience very little turnover as they are rebalanced only when the index is reconstituted (changed). Actively managed funds, by contrast, typically experience much higher portfolio turnover as active managers trade constantly in an attempt to replace “overvalued” securities with “undervalued” securities. One way to track the cost of a portfolio’s turnover is to observe the Tax Cost Ratio.

The Tax Cost Ratio measure how much of a fund’s annualized return is reduced by the taxes investors pay on distributions. For example, if a fund had a Tax Cost Ratio of 2% for a three-year period, and the fund’s pre-tax annualized return was 10%, an investor in the fund actually earned only 8%.

The table below shows the summary statistics of all Large Cap Value funds’ 10-Year Tax Cost Ratio and Turnover Ratio in Morningstar’s database:



Tax Cost

 Turnover Ratio

Summary Statistics

Ninetieth Percentile



Eithtieth Percentile



Seventieth Percentile



Sixtieth Percentile



Fiftieth Percentile



Fortieth Percentile



Thirtieth Percentile



Twentieth Percentile



Tenth Percentile






The table clearly shows a higher tax burden is created by higher levels of turnover. It also shows the average Large Cap Value fund lost 1.08% annually over the past 10 years due to taxes – a significant number since the Large Value asset class only returned 3.07% over the same time period. Comparatively, the Large Cap Value position used in portfolios managed by Capital Directions has a 10-year Tax Cost Ratio of 0.49, placing it well within the top percentile of the most tax-efficient funds.

3. Practicing Asset Location: Asset location refers to the intentional placement of assets into specific types of accounts based on their predominant source of return. Due to differing tax treatment of capital gains and income, it is prudent to invest securities whose gain will be subject to ordinary income rates (typically much higher than capital gain rates) in tax-deferred accounts to the greatest extent possible.

Prudently placing investments in the correct account allows for a higher after-tax return without assuming any additional risk. It’s the closest thing to risk-free return an investor will ever get.

Unfortunately most investors – and their advisors – still populate tax-deferred and taxable accounts with similar securities. This is a shame, because a study by Carnegie Mellon University showed that investors can lose up to 20% of their after-tax returns by mislocating investments.

By following these three rules, investors can take significant strides to keep the returns they have earned for the risk they assumed. Remember, it’s not what you earn that matters: It’s what you keep.

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