Seminal Research

And it came to pass in those days, that there went out a decree from Caesar Augustus that all the world should be taxed.

—New Testament

Experienced advisers often wonder why it took until the 1990s b e fo re tax- aware investment management began to gain traction. One of the many reasons for this was the lack of research avail-abl e t o the investment community and investors. To conduct any type of analysis t akes two main ingredients: knowledgeable individuals to conduct the exe rc ise an d a means to measure results on the subject they wish to investigate. The first research ingredient was present in academics, s u ch as George M. Constantinides, a noted professor at the University of Chicago, who wrote several outstanding articles in the early 1980s.1 His work addresses optimal trading of both stocks and bonds, and he coau th o re d an article with Myron S. Scholes on asset pricing that takes into account the impact of personal taxes. Furthermore, a review of his refe rences quickly reveals there had been a great deal of work taking taxes into account by noted individuals in the 1970s. However, the mores ophisti cat ed res earch of the time emphasized how taxes influenced the pricing of securities, rather than whether or not analysts and portfolio managers took them into consideration. The other essential ingredient is havin g a way to measure results. Unfortunately, we still do not have dat ab ases or methods to accurately measure after-tax results of separate account managers in any meaningful way. To do this we must still rely on information from mutual funds, which is historically still a relatively young industry. Whereas the first fund was launched in Boston in 1924, the re al s truct u re and re gulat o ry framework for the industry was not put into place until 1940, and the number of funds did not surpass 500 until 1978.2

" I s Your Apha Big Enough to Cover Its Taxes?" published in the Jour-na I of Portfolio Management in the spring of 1993, was the first article to use mutual fund tax-related information to truly capture the impact on investment returns.3 The story behind this article is worth sharing, as it o ffers s everal valuable lessons.4 The article was coauthored by Robert D. Anott and Robert H. Jeffrey. At the time the article was prepared, Arnott was the president of First Quadrant, a firm recognized for quantitative investing and insightful research. Most recently, he founded his own firm, Research Affiliates, and is the portfolio manager of the highly successful PIMCO Al Aset Fund. Known as a prolific author and coauthor of numerous articles on an array of investment-related subjects, Arnott also s erves as ed i t o r o f the Financial Analysts Journal, the research journal of the CFA Institute. Robert "Tad" Jeffrey is a hands-on practitioner and has published several noteworthy articles,as well.

I n 1974, Jeffrey's family's company sold a manufacturing subsidiary for cash. Therefore, the family had to make a major adjustment from managing operating companies to overseeing a taxable portfolio. Having been a his t o ry major, Jeffrey had to learn quickly. It was probably a blessing in disguisethat he did not haveaformalinvestmenteducation,as histhink-ing was notinhibited by traditional portfolio management practices.

Jeffrey made a very wise move by asking none other than Peter L. Bernstein to assist as a consultant to the company. Bernstein had been a te acher at Williams College. Shortly after his departure, Jeffrey enrolled there as a s tud ent . They met later and developed a warm friendship over the years , and Jeffrey affection at ely refers to Bernstein as his professor.

Bernstein introduced Jeffrey to some of the most noted personalities in academia, investment management, and pension consulting. Throughout the 1980s Jeffrey sent letters to these individuals, such as the late Peter O. Dietz of Frank Russell Co., seeking more efficient ways to manage taxable ass ets . 5 Meanwhile, Jeffrey continued to hear of firms that could possibly address his special need but that they had all the business they could handle from the mainstream and would find it uneconomical to divert their resources. Jeffrey even sent Jack Bogle ofVanguard a letter suggesting launching a product similar to the Windsor Fund that would explicitly take the impact of taxes in to consideration , b u t Vanguard would not directly ad dress the need until some nine years later when it launched the " Tax-Managed"series offundsin 1994.6

Like Tad Jeffrey, Rob Arnott was concerned about the impact of taxes on his own portfolio. Knowing that both individuals had a passionate interest in the s ubject, Bernstein introduced them after one of Arnott's articles on taxable account investing had b een rejected by Financial Analysts Journal. As Arnott tells the story, he had written an internal piece on how trading affects after-tax results and s hared it with Jeffrey. After reading the article, Jeffrey remarked, "This is great, but we need to put something in English so the average individual can understand it!" To address Jeffrey's concern about s implicity, they decided o n a more real-world versus theoretical app roach. They compared the after-tax performance of all funds classified by Morningstar as "growth" and "growth and income" that had at least $100 million in assets throughout the period of 1982 to 1991. Obviously, there is s urvivor bias in the s tudy, as many lesser-performing funds that could not attract and maintain the $100 million threshold were eliminated. Rather than apply the maximum federal tax rates for individuals, they applied a 3 5 p ercent rate s o that the results would apply to the various types of taxable accounts. The results from seventy-one funds studied were compared with the Vanguard 500 Index Fund, and also with a fictional "Closed-End I ndex 500" as a better benchmark, since mutual funds are subject to tax implications from shareholder redemption activity. The latter is a valid comparison b ecause, as Jack Bogle has stated, close scrutiny on redemption activity did not begin until sometime later, and the after-tax results of the Vanguard 00 ndex Fund would have een higher f urrent ontrols ad been in place.7 FIGURE 3.1 gives the key results of their study.

« £ o Q-cr figure 3.1 Number of Large Actively Managed Mutual Funds of Seventy-One That Outperformed the Respective

Index Fund (1982-1991)

"closed-end

vanguard

total return

index 500"

500 index

Pretax

15

15

After Capital Gains Taxes

5

10

After Capital Gains

and Dividend Taxes

6

Including Deferred 10 13

After All Taxes

Including Deferred 10 13

Readers, especially those in the investment management community, were shocked to discover not that only 21 percent (15 out of 71) funds beat the Vanguard 500 Index Fund on a pretax basis but that only 13 percent (9 o ut o f 71) o utperformed o n an after-tax b asis, o nce taxes o n capital gains and dividend distributions were accounted for. This method of calculation is now known as the "pre-liquidation methodology," as the tax on the unrealized capital gain or loss position is not taken into account. Since large-capitalization s tock index funds have very l ittle turnover in their holdings, capital gains distributions are p rimarily attributable to shareholder activity o r mergers and acquisitions that are consummated as a taxable cash transaction rather than as a tax-free exchange o f shares. Therefore, all else being equal, index funds are likely to have greater embedded unrealized capital gains positions than actively managed funds that are consistently generating capital gains through the s ale and purchase of individual securities. Even with the most conservative post-liquidation calculation only 1 7 percent (13 out 71) of the funds outperformed the Vanguard 500 Index Fund on an after-tax basis.

Of the thirteen mutual funds that outperformed the Vanguard 500 I ndex Fund on an after-tax basis, only two did so by a meaningful margin (see FIGURE 3.2). These were the CGM Capital and Fidelity Magellan funds managed by legendary managers Ken Heebner and Peter Lynch, respectively. The helm of Fidelity Magellan has changed hands several times s ince Peter Lynch managed the fund, but neither fund has repeated

figure 3.3 Ten-Year After-Tax Performance (for the Ten Years

Ending 12-31-2004)

mutual fund

return after taxes on distribution

return after taxes on distribution & sale

CGM Capital Development

8.60%

8.31%

Fidelity Magellan

8.54%

8.11%

Vanguard 500 Index

11.32%

10.34%

over the past t en years , as FIGURE 3.3 shows.8 Part of the two funds' in-ab ility to o utperfo rm an index fund can be explained by their growth s tyle o f inves ting b ein g out o f favor for the past five years. However, the point of this example is to highlight how difficult it is to outperform the ind ex o n after- tax basis over a long period of time and then to repeat the feat in the future.

Even after more than a decade, "Is Your Alpha Big Enough To Cover I ts Taxes ?" is s t il l co nsidered the seminal article in tax-aware investing, as it cle arly demonstrated the difficulty in attempting to outperform a low-fee, large- capitalization index fund on after-tax basis when relying on tradi-tio nal portfolio management practices. The study also highlighted how tax consequences are more a factor of the holding period and their impact diminishesasturnoverincreases. Itsimpactontheindustry has been pro-fo und, as it underscored the amount of research that needed to be done n n n e n

Over the years, financial services entrepreneur Charles Schwab developed a supportive relationship with Stanford University. He funded the Charles R. Schwab Professor of Economics position, which was filled by professor John B. Shoven.9 After launching the Schwab 1000 Index Fund with the thought of offering a product with a favorable tax orienta-tio n, Charles Schwab approached Shoven to conduct two studies. The first study was to illustrate the impact taxes have on mutual fund returns. Schwab was hoping the conclusions of the study would support his vision o f a need for a tax-aware fund, and the market would therefore embrace his firm's new product.

To s at is fy Schwab's request , Shoven enlisted Joel M. Dickson, a grad-u at e s tu dent who had a special interest in mutual funds, to cowrite the working paper, titled "Ranking Mutual Funds on an After-Tax Basis." 10

The project kept the coauthors busy, as they soon found out that the data they o btained from the Investment Company Institute (ICI) required a 1 ot o f s cru b bing b efore they co uld draw meaningful conclusions with any degree of confidence. They analyzed returns going back ten, twenty, and thirty years and applied tax rates applicable to low-, middle-, and high-tax-bracket families. Dickson and Shoven noticed the Vanguard 500 I ndex Fund improved in relative performance, moving from 78.9 on a before-tax basis to the 85.0 on after-tax basis. They also calculated that if the s mall amount of capital gains distributed had been zero, then the p erformance would have ended up at the 91.8 percentile. These results were consistent with findings of Arnott and Jeffrey and supported the conclusion that mutual fund managers were paying little attention to the impact o f taxes .

Dickson and Shoven analyzed 147 of the largest growth and growth and income mutual funds from 1983 to 1992 using ICI data. Since the first index mutual fund did not come about until 1976, they focused their atte ntion on how managers changed in relative ranking between before-and after-tax performance in relation to their turnover rates. When they 1 o oked at the performance of individual funds, they found some interesting surprises. As might be expected the fund with the lowest turnover, Franklin Growth (only 3-2 percent annually), jumped 33-8 percentiles in ranking, but the fund with the highest turnover, Fidelity Value (296 p erce nt), improved more than any other fund with a jump of 35.4 percentiles. The Dickson and Shoven study shows only a small negative correlation between turnover and the pre- to post-tax performance ratios. Moreover, the coauthors believed the results were not statistically significant. In essence, what their study proved is that you simply could not make broad sweeping statements about portfolio turnover and the impact o n after-tax performance. At the time they probably did not envision how s age the comment "We feel that managing a fund so as to defer all capital gains realizations is feasible" would prove to be some ten years later, as the Schwab 1000 Index Fund has not made a capital gain distribution s ince its inception in 1991. Actually, this statement was really a prelude of more things to come, as Charles Schwab's second request was for Shoven to address methods that could be used to operate a mutual fund without generating capital gains. Just a year after publishing the first paper, they would coauthor "A Stock Index Mutual Fund Without Net Capital Gains Realizations."n The importance of this work will be covered in greater detail in chapter 9, which addresses methods used to outperform index u n n n n d

I n 2000, Rob Arnott revisited the subject he had addressed seven years earl ier with the follow-up paper "How Well Have Taxable Investors

£ ^ M i CÛ o

figure 3.4 Margin of Gain and Shortfall vs. Vanguard

B =

Index 500

? 3

O ,y « E

avg. margin

avg. margin

- -SZ

total return won

of gain

lost

of shortfall

û E

Pretax Returns

15

1.8%

56

.Û c ™ 0 a!

After Capital Gains

5

1.0%

66

A3 CO

After Capital Gains

% ¡E on

and Dividend Taxes

6

0.9%

65

-3.1%

After All Taxes

O) |_ f-j -û ^ O iü 0) ~ £

Including Deferred

10

1.1%

61

CO 1— <

Been Served in the 1980's and 1990s?"12 With his associates Andrew L. Berkin and Jia Ye, he went back to the original study and came up with an interesting observation that, upon further analysis, the magnitude of the average margin of shortfall by the large number of funds underper-form ing was much greater than the average margin of gain on the funds that outp erformed the Vanguard 500 Index Fund on an after-tax basis (s ee FIGURE 3.4).

With the growth in the mutual fund industry there were now many more funds to analyze. Therefore, the longer time horizon and the greater number of observations could reinforce the validity of or possibly refute their earlier findings. They studied three time horizons: ten years (19891 998) , fifteen years (1984-1988), and twenty years (1979-1988). Depending on the period and type of calculation method, only 4 percent t o 16 percent of the mutual funds consistently having more than $100 million in assets outperformed the Vanguard 500 Index Fund on after-tax

T e e h o d e u m h n s t udyand validatedtheclaims made years earlier.

I n this s tudy, the coauthors also subtracted the before-tax return differe n tial fro m the after-tax results between the funds and the Vanguard 500 Index Fund to achieve a "pure tax effect." There are several interestin g observations (see FIGURE 3.5). First, since the Vanguard 500 Index Fund has outperformed most funds on a before-tax basis, the differential is not as dramatic as previously shown. Second, the total column is always negative, which shows that the average fund pays more taxes than the ind ex fund. Lastly, note how the percentages improve in each case figure 3.5 Mutual Fund Pure Tax Effect vs. Vanguard 500 Index Fund

ahead of vanguard 500 index

number of funds

margin above vanguard 500

10-Year Results (1989-1998)

After Capital Gains Taxes

6

2%

0.21%

After Capital Gains and Dividend Taxes

31

31%

0.39%

After Liquidation

125

35%

0.50%

15-Year Results (1984-1998)

After Capital Gains Taxes

7

3%

0.26%

After Capital Gains and Dividend Taxes

17

8%

0.60%

After Liquidation

53

26%

0.60%

20-Year Results (1979-1998)

After Capital Gains Taxes

5

3%

0.37%

After Capital Gains and Dividend Taxes

16

10%

0.75%

After Liquidation

44

27%

0.56%

when you go from the row marked "After Capital Gains" to the row marked "After Capital Gains and Dividend Taxes." Common stock mutual funds can apply the income from dividends to offset fund expenses, which lowers the tax burden to the shareholder. Since fees of actively managed funds are much higher than the 20 basis points or less for the Vanguard 500 Index Fund this tax saving is meaningful.

This also addressed the issue of survivor bias, which was not address ed earl ie r. As expected, when this factor was taken into account the results favore d the Vanguard 500 Index Fund even more. As with the p revi o us s tudy, in formation provided by Morningstar made this study possible.

behind vanguard 500 index margin above number of funds vanguard 500 total margin above number of funds vanguard 500 total

349

98%

-1.68%

-1.65%

324

91%

-1.27%

-1.12%

230

65%

-0.47%

-0.13%

196

97%

-1.63%

-1.56%

186

92%

-1.20%

-1.05%

150

74%

-0.53%

-0.23%

157

97%

-1.49%

-1.43%

146

90%

-1.00%

-0.83%

118

73%

-0.56%

After-tax investing is a noble objective, but is there evidence to suggest that investors have taken notice? In their paper, "Do After-Tax Returns Affe c t Mutual Fund Inflows?" authors Daniel Bergstresser and James Poterba

0 f the MIT Department of Economics offered evidence to suggest that high tax burdens are associated with lower gross inflows, and mutual funds that offer higher after-tax returns attract greater inflows.13 They studied a

1 arge s ample of equity mutual funds from 1993 to 1999- It is encouraging that Bergstresser and Poterba discovered that investors took noticeable s teps t o protect themselves, as it was not until the end of this period that the financial press began to address in a meaningful way the adverse financial co nsequences from potentiallargecapitalgains distributions.

Review of the key articles on tax-aware investing highlights four important factors. First, change in the financial management industry requires a vis i o n. Both Tad Jeffrey and Charles Schwab addressed an issue that others ignored. Through two decades of persistence and interaction with countless p rofess io nals Jeffrey should be designated as the "father of tax-aware investing," and due to his financial support Charles Schwab be known as "the godfather of tax-aware investing." The second point is it often takes gifted individuals to communicate the dreams of others. Therefore, we need to be thankful that Rob Arnott, John Shoven, and Joel Dickson reco gnized the issue and were able to communicate their conclusions in a mannerthat allowedpractitioners andinvestorstotakeaction. Third, the co ntent of materials available to the investor will continue to improve as needs are addressed by service providers and regulators. To demonstrate how the industry has progressed, refinements in the Morningstar Principia datab as e now allow individual investors to conduct their own after-tax mutual fund analysis—which would rival the pioneering work done by res earchers with advanced degrees only a decade ago—on almost any ass et class in a matter of minutes! Fourth and lastly, while most stock funds have underperformed the Vanguard 500 Index Fund on an after-tax basis, it does not mean all funds should or will underperform in the future. Since we now understand what causes lackluster after-tax performance, enlightened practitioners are now offering and creating distinctive services and products. However, compelling results cannot be achieved unless investors or their trusted advisers are able to identify the growing number of uniquely qualified tax-aware professionalsinthe marketplacetoday.

Chapter Notes_

1 . George M. Constantinides and Myron S. Scholes, "Optimal Liquidation of Assets in the Presence of Personal Tax," Journal of Finance vol. 35, no. 2(1980): 439-449; George M. Constantinides, "Capital Market Equilibrium With Personal Tax," Econometrica 51 (1983): 611-636; George M. Constantinides, "Optimal Stock Trading With Personal Taxes: Implications for Prices and the Abnormal January Returns," Journal of Financial Economics, 13 (1984): 65—89; George M. Constantinides, "Optimal Bond Trading With Personal Taxes," Journal of Financial Economics, 13 (1984): 299—335.

2 . Inves tment Company Institute, Mutual Fund Fact Book 2004 (Washington, D.C.: Investment Company Institute, 2004), 105.

3 . Robert H. Jeffrey and Robert D. Arnott, "Is Your Alpha Big Enough To Cover Its Taxes ? The Active Management Dichotomy," Journal of Portfolio Management (Spring 1993): 15—25.

4. Robert D. Arnott, Peter L. Bernstein, John C. Bogle, and James P. Garland and Robert H. Jeffrey, in discussion with the author, August 30, September 1, S eptember 2, and August 4, 2004, respectively.

5. Robert H. Jeffreyto Peter O. Dietz, April26,1983.

6. Robert H. Jeffrey to John C Bogle, May 29,1985.

7. John C Bogle,in discussion withthe author, September 2, 2004.

8. Morningstar Principia, June 30, 2004.

9. Joel M. Dickson,in discussion with the author, September 21, 2004.

10. Joel M. Dickson and John B. Shoven, "Ranking Mutual Funds on an After-Tax Basis," NBER Working Paper no. 4393, National Bureau of Economic Research, July 1993.

11. Joel M. Dickson and John B. Shoven, "A Stock Index Mutual Fund Without Net Capital Gains Realizations," NBER Working Paper no. 4717, National Bure au ofEconomic Research, April 1994.

12. Robert D. Arnott, Andrew L. Berkin, and Jia Ye, "How Well Have Taxable Inves tors Been Served in the 1980s and 1990s?" Journal of Portfolio Management vol. 26, no. 4(Summer 2000): 84-94.

13. Daniel Bergstresser and James Poterba, "Do After-Tax Returns Affect Mutual Fund Inflows?" Journal of Economics vol. 63, no.3 (2002):381—4l4.

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