I have mentioned in the past that I like active management, assuming the proper due diligence is performed. However, one thing I didn’t mention is the impact of taxes.
Passive management tends to have a lower tax burden than active management. This is because passive managers follow an index and thus have little turnover (e.g. buying the 500 stocks in the S&P 500 and holding until the index changes). Active management on the other hand tries to beat the index and may therefore have higher turnover. Higher turnover = higher capital gains distributions = higher taxes at the end of the year.
Higher taxes mean a lower net return. When looking at client portfolios, we always manage for after-tax return because that is what the client brings home. Returns can look great on the surface, only to get dinged by taxes.
Is higher turnover a negative aspect of active management? Absolutely, but it isn’t a death knell. First, having the proper manager is still paramount to tax savings. Keeping your taxes lower is part of the manager discussion, but certainly not the end all be all. Second, you can still manage for after-tax rate of return and have active managers:
- Keep high turnover funds in tax-deferred accounts
- Tax loss selling to offset your gains
- Utilize active managers that have lower turnover
- Blend in passive managers to go along side your active managers
Important -
Capital Advisors LTD and Capital Analysts does not provide Tax advice. Contact your tax advisor for review, implications, and applicability of any tax strategy to your situation. This tax information is provided for educational purposes only and is not a recommendation. Pursuant to recently-enacted U.S. Treasury Department Regulations, we are now required to advise you that, unless otherwise expressly indicated, any federal tax advice contained in this communication, including attachments and enclosures, is not intended or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.
