Fool’s gold: Don’t bank on pre-tax returns

Oct 28, 2021
  • Michael Lane

Taxes are much in the news again, as legislation percolates through Congress that could impact both capital gains and ordinary income tax rates. It is a topic that is coming up in a great many of my conversations with advisors these days. I tell them that I won’t attempt to predict the final result of any potential legislation; instead, I emphasize that the potential impact on taxes on a portfolio should always be an important consideration in the portfolio construction process.

In other words, while a particular strategy to minimize a tax impact may change if markets are up or down in a given year, finding ways to improve portfolio tax efficiency for clients is relevant across asset classes and in all market conditions. Although overall tax considerations are easy to overlook, building tax efficiencies into the portfolio construction process can help clients reach their financial goals. Each day, advisors I speak with are focused on every basis point of cost, yet many still forego hundreds of basis points in lost compounding due to tax inefficient portfolio construction.

Tax consequences can affect portfolio returns. In fact, taxes have proven to have a greater impact on long-term returns for taxable equity investors than fund management fees.1

Indeed, taxes on distributions shaved 1.69 percentage points off the average annual performance of alpha-seeking (actively managed) U.S. Large-Cap Blend mutual funds for taxable investors in the decade ended in 2020.2

Tax drag lowers returns

Tax drag lower returns

2 Source: BlackRock. The chart is for illustrative purposes only and is not indicative of the performance of any actual fund or investment portfolio. Does not include commissions or sales charges or fees. 12% represents the average pre-tax return over the same 10 year period for large cap equity mutual funds (12.30%). The hypothetical growth of $1,000,000 over ten years at an 12% return is $3,105,848.
The hypothetical growth over ten years at an 12% return with a 1.79% tax cost is $2,643,687, resulting in a tax cost of $462161.

Two sources of taxes

There are two primary sources of taxes for fund investors. The first is income taxes due on dividends or interest. The second is capital gain taxes resulting from the sale of a fund, or taxes due on capital gain distributions.

All registered investment companies are required to distribute realized portfolio gains to shareholders, regardless of performance and fund owners have to pay taxes on these distributions. Since many U.S. stocks inside fund portfolios have accrued significant unrealized gains since the global financial crisis, even minor portfolio allocation changes can trigger pent-up capital gains. Redemptions can be one trigger for allocation changes, as fund managers need to deliver cash on hand, or else raise cash by liquidating positions when dealing with redemptions.

Despite the recent growth of ETF assets, their low contribution to total capital gains has remained constant. Whereas 66% of alpha-seeking U.S. equity funds made a capital gain distribution in 20203, just 5% of iShares ETFs distributed capital gains. We at BlackRock feel actively managed funds can and do play a vital role in portfolio construction. But it is important to consider whether the taxes from fund cap gains distributions eliminate any alpha one may receive from a fund, particularly those that tend to mirror an index or a specific factor exposure.

ETFs contributed less than 1% of 2020's total capital gains distributions

ETFs contributed less than 1% of 2020's total capital gains distributions

 

Source: BlackRock analysis of Morningstar data (as of Dec. 31, 2020). Past distributions not indicative of future distributions

ETF tax efficiency stems in part from investment strategy. Most U.S. ETF assets under management, some 97%, are within strategies that seek to track the performance of indexes4. The most popular market cap-weighted indexes have lower portfolio turnover than alpha-seeking managed strategies. Low index turnover generally means fewer sales of appreciated stocks for index funds relative to alpha-seeking strategies.

Structural differences matter, too, and help explain why index ETFs have historically distributed fewer capital gains than index mutual funds.
Unlike with mutual funds, ETF investors typically do not interact directly with fund providers. Instead, in the vast majority of instances, ETF sellers interact directly with ETF buyers on exchange.

Strategies to help reduce tax impact

Many tax-conscious investors seek to systematically mitigate gains and/or regular income by tax-loss harvesting. Tax-loss harvesting is the act of selling investments that are down to realize a loss. Harvested losses can be used, dollar for dollar, to offset capital gains, potentially eliminating tax liabilities. Sometimes investors can harvest losses even when a fund has a positive total return. It’s sometimes difficult to parse out a fund’s negative price return (and potential harvesting opportunities) because mutual fund investors often have accounts configured to automatically reinvest distributions, and the account’s value often reflects the fund’s total return rather than its price return. In years like 2021, when all markets seem to be doing exceptionally well and there is little tax loss harvesting on the surface to consider, one has to observe the timing of their share purchases. There are many funds that are down 20-40% this year from their peak price, which provides an opportunity to offset gains from gains that will be distributed in December from many mutual funds.

Although tax efficiency should be a year-round consideration, tax management can prove especially useful in the fourth quarter of each year when many open-end mutual funds and ETFs announce estimates for capital gain distributions. These estimates give an investor a window of opportunity, and to the extent that they do not wish to receive the distribution, they can sell out of the fund in advance, being mindful that doing so might have its own tax implications. For example, it may not make sense to realize a larger capital gain in order to avoid receiving a smaller capital gain distribution. In situations where it is advantageous, an investor can use the selling proceeds to purchase a fund with similar exposure. By doing so, the investor can continue to pursue their strategic asset allocation and will not have received the distribution from the fund.

Summing up

Financial advisors and tax advisors have historically played distinct roles. Increasingly however, clients are demanding more integrated services. Advisors who include tax efficiency into their due diligence can help align practices with client objectives. BlackRock believes tax implications should feature more prominently into portfolio construction and fund due diligence — and we have tools that can help.

Sean Murphy contributed to this article.

For Professional Use Only – Not For Public Distribution.