While the debate over the merits of active versus passive investing is ongoing, there has been a very clear trend spanning several decades now showing that investors are slowly (but steadily) abandoning the hope of outperformance offered by active management in favor of the certainty of earning market returns (not average returns) offered by passive management.
This trend has proven inexorable as investors become increasingly aware of the low – and declining – odds that active management will outperform. For example, evidence presented in my latest book, The Incredible Shrinking Alpha, which I co-authored with Andrew Berkin, shows that while 20 years ago about 20 percent of active managers were generating statistically significant alpha, today that figure has fallen to roughly two percent. And that’s before considering the impact of taxes, which taxable investors will face.
Contributing to the trend is that, thanks to efforts like those of the research team at Standard & Poor’s, investors are becoming more cognizant of th"e relative performance of these two strategies. The most recent evidence comes from a September 2015 Standard & Poor’s research report. The report, which presents cross-country comparisons, provides a look at the global evidence covering the five-year period from 2010 through 2014. The following is a summary of its key findings:
- An overwhelming majority of actively managed domestic equity funds trailed their respective benchmarks across different markets.
- In the United States, 89 percent of active funds underperformed their S&P 500 Index benchmark. On a dollar-weighted basis, that underperformance was 1.7 percent.
- For developed countries, an average of 76 percent of active funds underperformed their respective benchmarks, with the dollar-weighted underperformance being 0.4 percent.
- In the supposedly inefficient asset class of emerging markets, an average of 80 percent of funds underperformed their respective benchmarks, with the dollar-weighted underperformance being 1.2 percent.
While these figures present a pretty dismal picture of active managers, for taxable investors, the reality is actually far bleaker. This occurs because, for taxable investors, the greatest expense of active management (caused by its relatively high turnover) is frequently taxes. Thus, the percentage of active managers who were able to outperform after taxes would almost certainly be far lower than the S&P Indices Versus Active (SPIVA) data indicates.
We’ll now take a look at some of the academic evidence on the impact of taxes on active management results.
In their 1993 study, “Is Your Alpha Big Enough to Cover Its Taxes?”, Robert Jeffrey and Robert Arnott found that over the 10-year period they studied, 21 percent of actively managed funds beat a passive alternative on a pre-tax basis, but just seven percent did so on an after-tax basis. They conclude: “The preponderance of evidence is so convincing we conclude that the typical approach of managing taxable portfolios as if they were tax-exempt is inherently irresponsible, even though doing so is the industry standard.”
We also have evidence from a 2000 study, “How Well Have Taxable Investors Been Served in the 1980s and 1990s?” Here’s a summary of its findings:
- The average fund underperformed its benchmark by 1.75 percent a year before taxes and by 2.58 percent on an after-tax basis. Taxes added a further drag of 0.83 percent.
- On an after-tax basis, just 14 percent of the funds outperformed.
Again, the story is actually worse than it appears because the data above contains survivorship bias (33 funds disappeared during the timeframe covered by the study). One more point on survivorship bias: Since the study covered only funds with more than $100 million in assets, it is likely that the survivorship bias is understated. The funds that have successful track records tend to attract assets. Funds with poor records tend to lose assets or be closed, never reaching the $100 million threshold of the study.
The authors of this study – Robert Arnott and Andrew Berkin, along with Paul Bouchey – updated it in 2011. They concluded that the typical approach for managing taxable portfolios (acting as if taxes can’t be reduced or deferred) remains the industry standard. Yet they estimated that the typical active fund must generate a pre-tax alpha of greater than two percent a year to offset the tax drag from its active strategies, and most funds cannot accomplish that feat. The finding of a tax drag in excess of two percent is consistent with the findings from other studies.
It’s important to consider that because of the two bear markets we experienced in the first decade of this century, the impact of taxes on returns has been less than the long-term experience. That is why it’s important to look at data from prior periods.
The evidence is so overwhelming, that Ted Aronson of AJO partners, an active institutional fund manager with about $24 billion in assets under management, offered this advice: “Once you introduce taxes, active management probably has an insurmountable hurdle.”
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