The Tax Man Cometh
Programming Note--the Carnival of Personal Finance is being hosted by Canadian Capitalist at canadiancapitalist.com. Check it ouut.
"Let me tell you how it will be
There's one for you, nineteen for me
Should five percent appear too small
Be thankful I don't take it all
Cause I'm the Taxman"
George Harrison
A huge road bump on the highway to wealth is taxes. And here's all you need to know--if you invest in index funds you are investing in the lowest cost and most tax effective funds on the planet. So if you are currently investing in index funds you can get quit reading and get back to work.
If not or you don't want to get back to work, keep reading. Tax efficient funds are noteworthy for three things--low fees, low transaction costs and low tax costs. Inefficient tax funds are noteworthy for just the opposite--high fees, high transaction costs and high tax costs.
What is the one element that differentiates the two funds? Turnover.
Remember that finance is simple and so is turnover. Turnover is the number of stocks the manager sells in any given period, usually one year. And turnover generates cost.
A brief look at the workings of two funds will highlight the differences.
But first a word on taxes and taxable events--the IRS only taxes you when you recieve income, ie. cash. There are some prissy exceptions but not germane here. If you buy a stock, it goes up 10% in one day and you sell it, you are taxed at your ordinary income tax rate that can be high as 36.5%, I think. If you hold the stock for one year and one day and then sell it, you are taxed at a max of 15%. If you buy a stock and it goes up 1,000% and you hold it, you are not taxed. You have to sell to have a taxable event. Back to our two fund managers.
Being a manager of an index fund, like a S&P index fund, must be the easiest and most boring job in the world. The S&P manager buys all the Standard and Poors 500 stocks in a ratio of their relative size to the index. Then he goes and plays golf. He is dragged off the golf course for only two events--cashing in a dividend or selling a stock when it merges or goes bankrupt. He plays golf at a municipal course because he can't afford a country club because he doesn't get paid very much. And the fund is tax efficient because it doesn't have a lot of turnover. The only two taxable events are the occasional dividend and perhaps when a company is sold or taken over.
The opposite manager is the manager of a managed fund. I went googling this morning and threw a dart and came up with the Fidelity Agressive Growth fund. Ok, I didn't throw a dart. I saw aggressive and that means managed to me so went there. This manager is a nervous wreck because he has to outperform the market to keep his job which means he has to hit a lot of home runs to cover his transaction fees (costs involved in buying and selling stocks) and the fee he charges to pay his huge salary. And he could care less about your tax problem.
So let's compare the two funds. The Vanguard S&P Index fund has a fee of .18% and a turnover ratio of 6.4%. This guy is probably a really good golfer because he only sells 6.4% of the portfolio every year. But he is also living in refrigerator box because his fee is only .18%.
The Fidelity Aggressive Growth Fund manager has a fee of .79%. That's not bad for a managed fund but over four times the fee for the index fund. Eats into your return over time. And the turnover ratio is 192%. WHAT? That's right, 192%. I was a little weak in statistics in grad school but this means to me that this manager buys and sells every stock in his portfolio twice a year. Whatever it means this guy is busy and a broker's dream because he is incurring transaction costs to buy and sell every stock at least twice last year.
And every one of those 192% transactions is a taxable event. A mess at tax time.
To be absolutely fair I went to Fidelity's glossary page and looked up turnover. Their definition is "A measure of a fund's trading activity calculated by dividing total purchases or sales of a portfolio's securities (whichever is lower) by the fund's net assets." Huh? All I know is that when I see the words "total purchases or sales" and a figure like 192% somebody is very busy with my cash.
Finally, let's look at results. For 1 year, 5 years, and 10 years the Vanguard S&P Index returned 8.27%, 2.24%, and 8.85%, respectively. The Fidelity Aggressive Growth manager knocked the cover off the ball last year with a return of 18.2% but for the five year period he LOST 8.89% and for the ten year period he made 3.43%.
This is not picking on this particular manager. I think the story would be about the same for any managed fund. But finance is easy and buying an index is easy. Easy plus time will make for superior returns.
HOLD IT! This from the back of the room. There is always one smart aleck that sees an opportunity and their point is I DON'T CARE ABOUT TURNOVER OR TAX COSTS BECAUSE MY MANAGED ACCOUNT IS IN A 401K, OR ROTH, OR IRA, AND SO TAX COSTS AND TURNOVER DON'T COUNT.
Partially right. There are no immediate taxable events but do you really want a guy holding a stock for no time at all, do you want to pay the higher expense ratio, do you want to incur the transaction costs involved with 192% turnover and do you want sub-par performance? Didn't think so.
Point being for the young person: put a good percentage of your investments in index funds and cash out as little as possible?
Posted by: oso | March 06, 2006 at 03:57 PM