Contrary to one market pundit’s prediction that 2011 would be an “easy year for stock pickers,” last year turned out to be pretty tough for active managers.  Fully 84% of U.S. stock funds failed to keep pace with their index benchmarks.  The average fund lost 2.4% in 2011.  After factoring in taxes on capital gain distributions, however, results were even worse.  Taxes consumed an extra 1.8%, meaning investors lost money and were stuck with a tax bill, too.  Salt in the wounds, to be sure.

Index funds, by contrast, are more tax friendly by nature.   As there is no manager darting in and out of stocks based on market forecasts, trading activity is reduced.  Fewer trades help keep a lid on transaction costs, and also minimize realized capital gains.  By simply tracking the market, index funds ensure the lion’s share of return lands in investors’ pockets.

Consider Vanguard’s Total U.S. Stock Market Fund (symbol VTI).  The fund, which invests in all publicly-traded U.S. stocks, returned 1% in 2011.  Taxes on dividends reduced that by 0.3%, resulting in an after-tax return of 0.7%.  That may not seem like much.  But in 2011, it was nearly 5% more than what the average fund investor took home.

Longer term, the story is much the same.  From 2001 through 2010, Vanguard’s Total U.S. Stock Market Fund earned 3.75%.  With a tax burden of just 0.31% per year, 3.44% made its way to investors’ bottom lines.  Actively-managed large cap stock funds earned 3.22%, on average, before tax.  Taxes ate 0.73%, leaving only 2.49% for investors.

How much do taxes matter?  For every $1,000,000 invested, the difference between 3.44% and 2.49%, compounded annually over ten years, is $123,600.
Beyond making the tax-savvy decision to favor index funds, a few additional strategies Vista employs help ensure taxes don’t take too big a bite out of our clients’ returns:

  • Asset Location—Place highly-taxed assets (e.g. bonds and REITs) in tax-deferred accounts and favor more lightly-taxed stocks in taxable accounts.
  • Tax Loss Harvesting—Trim positions trading at a loss, immediately replace them with a similar investment, and use the realized (“harvested”) losses to wipe out future gains.
  • Municipal Bonds—Favoring tax-free over taxable bonds often has appeal for clients in higher tax brackets.  A muni bond yielding 3% delivers the same income as a 4.5% taxable bond.

We recognize how boring these strategies may appear relative to the dizzying complexity peddled by Wall Street.  And therein lies their appeal:  simple, sensible and quietly effective.  It sure beats salt in the wounds.