Is your Alpha Big Enough to Cover Your Taxes?

[jtvalue]

I saw a reference to these white papers in the book the "Warren Buffett Portfolio" by Robert Hagstrom.  As the papers (links below) by Robert Arnott state "Taxes are the biggest expense investors face - more than commissions and more than management fees".  "Approximately 2/3rd's fo the marketable portfolio assets in the United States have owners for who taxes are a major consideration."

 

The role of taxes in portfolio management receives far too little attention in my opinion     

 

http://www.ifaarchive.com/media/images/pdf%20files/isyouralphabigenough.pdf

 

http://www.researchaffiliates.com/Production%20content%20library/IWM_Jan_Feb_2011_Is_Your_Alpha_Big_Enough_to_Cover_Its_Taxes_Revisted.pdf

[randomep]

I saw a reference to these white papers in the book the "Warren Buffett Portfolio" by Robert Hagstrom.  As the papers (links below) by Robert Arnott state "Taxes are the biggest expense investors face - more than commissions and more than management fees".  "Approximately 2/3rd's fo the marketable portfolio assets in the United States have owners for who taxes are a major consideration."

 

The role of taxes in portfolio management receives far too little attention in my opinion     

 

http://www.ifaarchive.com/media/images/pdf%20files/isyouralphabigenough.pdf

 

http://www.researchaffiliates.com/Production%20content%20library/IWM_Jan_Feb_2011_Is_Your_Alpha_Big_Enough_to_Cover_Its_Taxes_Revisted.pdf

 

This is a great topic. I printed out the article but I am at work and I must read this on my commute home. But I want to jump in for now. The article seems fantastic, just the stuff I have been looking for.

 

Now please forgive me if you feel I am hijacking your thread. But everyone says the 3 killers of returns are: inflation, fees, and taxes. I think it is arguable which is worse in all circumstances. We are lucky to be in a time of low inflation, so we don't think about it too much (in terms of returns!).

 

I also have discussion on all three topics:

 

taxes: http://bovinebear.blogspot.com/2013/07/taxes-and-investment-returns.html

 

fees: http://bovinebear.blogspot.com/2012/09/my-investing-costs.html

 

inflation: http://www.cornerofberkshireandfairfax.ca/forum/general-discussion/inflation-fallacy/

 

I'll definitely comment on the article tomorrow. Now back to you jtvalue!

 

 

 

[racemize]

These are good articles, I wish I had read them before I wrote my own essays on the same topic!

 

Here are mine, if you are interested.  They say very similar things to the articles, but I think mine have a bit more data and hypotheticals (but of course, I'm biased).

 

https://www.dropbox.com/s/8om0k5hmvudz58a/2013-09-22%20Holding%20Period%20Essay.pdf?dl=0

https://www.dropbox.com/s/uwawteaj86zfz1l/2014-03-25%20Hurdle%20for%20Active%20Investors.pdf?dl=0

 

[beerbaron]

An this is the story why I have a shitload of cash doing nothing in my margin account and none in my tax free accounts. Adding a criteria that the stock has to be a super long term holding greatly diminishes the available companies available. Catalyst almost become your enemy.

 

I don't understand why the article says even a index fund has taxes tough. If I hold an ETF for 20 years, I ouly have to pay taxes at the end of the term. Regardless of the actual constituents of the ETF. Does the ETF get taxes on it's turnover?

 

BeerBaron

[JBird]

These are good articles, I wish I had read them before I wrote my own essays on the same topic!

 

Here are mine, if you are interested.  They say very similar things to the articles, but I think mine have a bit more data and hypotheticals (but of course, I'm biased).

 

https://www.dropbox.com/s/8om0k5hmvudz58a/2013-09-22%20Holding%20Period%20Essay.pdf?dl=0

https://www.dropbox.com/s/uwawteaj86zfz1l/2014-03-25%20Hurdle%20for%20Active%20Investors.pdf?dl=0

 

That's great work! Really well written.

[racemize]

turnover on mutual fund indexes generate taxes in general (e.g., 4% turnover), but for the last 10 years, they've managed to avoid any taxables due to inflows, is my understanding. 

 

I'm not sure if that is true for ETFs though.  This is from an article I found on it:

ETF Capital Gains Taxes

Low portfolio turnover strategies:

The sale of portfolio securities by a fund may trigger capital gains distributions to shareholders. Therefore, funds that experience lower portfolio turnover are generally more tax-efficient than those that buy and sell securities regularly.

 

Index strategies, which most ETFs and many mutual funds follow, generally have lower portfolio turnover than actively managed strategies. This is not always the case, however; some indexes rebalance frequently, and some active managers limit portfolio turnover to minimize capital gains distributions.

 

Additionally, the fact that most trading of ETF shares occurs on the secondary market, rather than directly with the ETF, may reduce the frequency with which the ETF needs to sell portfolio securities to account for share redemptions. Mutual funds that do not experience regular net outflows (outflows in excess of corresponding inflows) may also limit the sale of portfolio securities to meet redemptions.

 

In-kind redemptions:

Many ETFs require authorized participants to create and redeem shares in kind—that is, to exchange ETF shares for a basket of securities, rather than cash. This allows the ETF to avoid selling securities to raise cash to meet redemptions, and thereby also prevents capital gains distributions. Additionally, when redeeming in kind, an ETF can provide the authorized participant with the underlying securities with the lowest cost basis, further reducing the ETF’s tax burden. Other types of investment products, including mutual funds, may also use tax-efficient strategies to reduce capital gains, but the ETF structure encourages their use.

[beerbaron]

turnover on mutual fund indexes generate taxes in general (e.g., 4% turnover), but for the last 10 years, they've managed to avoid any taxables due to inflows, is my understanding. 

 

I'm not sure if that is true for ETFs though.  This is from an article I found on it:

ETF Capital Gains Taxes

Low portfolio turnover strategies:

The sale of portfolio securities by a fund may trigger capital gains distributions to shareholders. Therefore, funds that experience lower portfolio turnover are generally more tax-efficient than those that buy and sell securities regularly.

 

Index strategies, which most ETFs and many mutual funds follow, generally have lower portfolio turnover than actively managed strategies. This is not always the case, however; some indexes rebalance frequently, and some active m

anagers limit portfolio turnover to minimize capital gains distributions.

 

Additionally, the fact that most trading of ETF shares occurs on the secondary market, rather than directly with the ETF, may reduce the frequency with which the ETF needs to sell portfolio securities to account for share redemptions. Mutual funds that do not experience regular net outflows (outflows in excess of corresponding inflows) may also limit the sale of portfolio securities to meet redemptions.

 

In-kind redemptions:

Many ETFs require authorized participants to create and redeem shares in kind—that is, to exchange ETF shares for a basket of securities, rather than cash. This allows the ETF to avoid selling securities to raise cash to meet redemptions, and thereby also prevents capital gains distributions. Additionally, when redeeming in kind, an ETF can provide the authorized participant with the underlying securities with the lowest cost basis, further reducing the ETF’s tax burden. Other types of investment products, including mutual funds, may also use tax-efficient strategies to reduce capital gains, but the ETF structure encourages their use.

 

Another strategy I have explored would be to make a corporate entity in say, the Bahamas. For as long as I don't liquidate my shares of the corporate entity I should not have to pay taxes on it. anybody has input on this?

 

I find the derivative strategy proposed in the white paper to be painfull. It's like getting kicked in the knee instead of in the junk... painfull. Furthermore, selling s&P derivatives to offset your holding is a very dirty hedge.

 

I have always found that buying puts on an index if like trying to time the market. Selecting a single security that will outperform the general market, I can probably achieve. Finding the proper moment to time the S&P is just dumb.

 

 

BeerBaron

 

BeerBaron

[randomep]

The first article's basic conclusion is very very misleading. I am surprised nobody called them out on it.

 

The conclusion states that the difference between 100% turnover and 0% turnover is 2.1% or 6% vs. 3.9%, assuming a 35% tax rate.

 

The 100% turnover case $100 gains $114.94 CASH which is the 3.9% compounded.

 

The 0% turnover case $100 gains $220.17 in stock, but you have to sell the stock sometime! If you sold at 35% interest rate you would gain $143 which is 4.5%. That is a 4.5%-3.9% = 0.6% difference! Our purpose to invest is to gain money in our lifetimes to spend, and even if you will it to your kids it will get taxed if you give it to them in kind.

 

Maybe these numbers make sense if you will it to a charity but then again, we most of us aren't rich enough or altruistic enough to do that..... :)

[jtvalue]

Morningstar recently released an interesting article & chart quantifying the impact of taxes on returns.  Since 1926, assuming 20% annual turnover, taxes have reduced stock market returns by 200 bps annually.  See the link below:

 

http://www.morningstar.com/Cover/videoCenter.aspx?id=667163

 

 

[matts]

An this is the story why I have a shitload of cash doing nothing in my margin account and none in my tax free accounts. Adding a criteria that the stock has to be a super long term holding greatly diminishes the available companies available. Catalyst almost become your enemy.

 

I don't understand why the article says even a index fund has taxes tough. If I hold an ETF for 20 years, I ouly have to pay taxes at the end of the term. Regardless of the actual constituents of the ETF. Does the ETF get taxes on it's turnover?

 

BeerBaron

 

My understanding is that most ETFs are legally funds. So yes, the fund will be taxed for all it's income (dividends, interest, realized gains ect), even if you don't get taxed until you sell the instrument.