Posts tagged taxes

On the forum there is a thread about implementing the Permanent Portfolio in a taxable account. I run a largely taxable portfolio so this subject is important to me. Taxes are expensive and proper portfolio management needs to consider their costs. Unfortunately, much advice in the area assumes the investor is using tax-deferred accounts. This means tax inefficient funds that may appear to have good results in a vacuum suddenly are mediocre once Uncle Sam takes his cut. A complicated portfolio can, by my estimate, lose somewhere in the 1-1.5% range a year in returns due to taxes and higher expense ratios. The advantage of complexity (if there was one) suddenly no longer exists vs. the simple portfolio.

I am reposting my edited replies here so hopefully others will consider why it is important to keep a portfolio simple (but especially so for any portfolio that is held in a taxable account):

In a taxable portfolio the more funds you add the higher your tax bill. The specialty/value funds as a general rule all have much lower tax efficiency than broad based index funds. Some small value funds can lose over 1% a year in returns just due to tax impacts. Translated in layman’s terms: You are taking on additional risk in these small value plays but Uncle Sam is getting the reward in higher taxes.

I looked at this issue forwards and backwards many years ago. I even designed a spreadsheet that would apply historical tax rates to model portfolios to estimate after-tax performance. The takeaway was this: A broad based index fund produced nearly identical returns vs. a more complicated portfolio if you subtract likely tax loads and costs. If tax rates went up above historical averages then the simpler portfolio beat the complicated portfolios just by avoiding the higher taxes.

With the tax rates about to go back up I suspect the gap may definitely narrow enough to benefit broad based index funds.

You can always add more funds later to your portfolio if you feel like doing it. But if you are running a taxable portfolio I implore you to keep it very simple and watch your tax efficiency. It is very expensive with capital gains, etc. to undo a taxable portfolio allocation you don’t like. So tread very carefully before you add in a bunch of funds that you may later wish weren’t there due to their tax loads.

Voice of experience here. Take it for what it’s worth. I think all portfolios should be as simple as possible. But taxable portfolios should be especially careful about keeping things simple.
I look at tax efficiency as really low hanging fruit that benefits taxable investors. It’s far more of a sure thing going for lower taxes vs. slice and dice in a taxable account. With the very high likelihood that taxes are going to continue going up you want to get your ducks in a row now for your portfolio in terms of managing the almost certainly higher costs. I encourage taxable investors to take a very long term view of asset class ownership. Not just years, but decades. It is very expensive to correct a portfolio with funds you no longer want. If you keep it simple it is likely you’ll have less regrets.

You just can’t go in like you can in a tax-deferred account and re-swizzle things if you hate your funds. There are costs associated with it. Imagine getting into a fund that is lagging the market for years and you don’t want it. But it has capital gains in it. It hasn’t matched the market, but it’s come close. But it’s also throwing a lot of dividends in your lap and generating capital gains taxes from internal turnover. Now you have to decide whether you just hang onto the thing because of the capital gains taxes you pay or dump it now and limit the damage going forward. It puts investors in a bad situation, what is sometimes called Morton’s Fork:

The expression originates from a policy of tax collection devised by John Morton, Lord Chancellor of England in 1487, under the rule of Henry VII.

His approach was that if the subject lived in luxury and had clearly spent a lot of money on himself, he obviously had sufficient income to spare for the king. Alternatively, if the subject lived frugally, and showed no sign of being wealthy, he must have substantial savings and could therefore afford to give it to the king. These arguments were the two prongs of the fork and regardless of whether the subject was rich or poor, he did not have a favorable choice. – Wikipedia

I have a dataset which goes back to 1926. The data reflects the range of CRSP indices for total market, small cap, etc. I am somewhat suspicious of index data rendered from historical data when no index existed, but it’s the best I’ve got. I applied the average tax loads Morningstar had for those sector funds with 10+ years of data as a “likely” historical tax cost. I then applied a table of historical US tax rates on capital gains to the rebalancing operations that happened each year (Long term capital gains average around 25%). I also subtracted the likely average costs of these funds (specialty value funds are more expensive than broad based index funds but nobody ever subtracts those costs from the historical returns). All these costs were subtracted from the annual returns before recalculating the next year’s results (no sense in compounding money you wouldn’t have due to taxes and expense ratios).

My estimate is a slice and dice portfolio could lose anywhere in the 1-1.5% a year due to taxes and management fees.

The result could be debated on some levels. But the overall outcome I think reflects the reality of tax losses and costs in very complicated portfolios. Just by avoiding paying additional taxes on things like rebalancing and not owning funds with high turnover you keep more of your money. It’s not that groundbreaking really, but I hadn’t seen anyone else looking at the issue.

It is interesting to me because it’s just not something most people considered in these complicated portfolios. Many of them assume the investor is working in 100% tax-deferred space. But if you’re not then these approaches are likely going to be very expensive to implement over time. Any theoretical performance advantage is likely going to be eaten up by Uncle Sam (or awfully close).

I had made similar changes to Simba’s spreadsheet but didn’t want to release it as it altered things too much in his code. I think however if Simba made those changes it would be interesting to many people.

As Jack Bogle has said many times: “Costs matter!” Not just expense ratios, but taxes as well. Taxes and expenses are an excellent reason why I encourage investors to keep their portfolios simple.