Triple net returns and the importance of taxes
- December 28th, 2011
A few weeks ago we talked about how even a relatively benign, by headline standards, inflation environment inflation is a “silent killer” of investment portfolios. The second constant for investors that is rarely written about is taxes. Taxes are not a sexy topic for bloggers or for the financial media. One reason why is that a big part of the investment universe is filled with investors like endowments and pension funds that don’t have to worry about taxes. The second reason is that taxes, unlike market trends and themes, don’t change all that much. Therefore the media pays attention to the squiggle of market prices more than the laws coming out of Washington.
However one can argue, like the Turnkey Analyst did in a post earlier this year that taxes are a much more important lever to pull for taxable investors than alpha. This is due in part to the fact that taxes are are a more predictable source of returns than alpha ever can be. Another way in which the issue of taxes comes up for individuals has to do with collective investment vehicles like mutual funds and ETFs.
One of the big arguments for ETFs has been their more efficient way of dealing with taxes. Over time ETFs have consistently paid out less in the way of capital gains distributions than their mutual fund cousins. The chart below via Meb Faber and iShares shows the tax cost to various actively managed mutual categories over the past decade. For taxable investors the drag of taxes on returns can add up to 2.0% per year. In a world of o% interest rates this detriment to returns can really add up.
It is for this reason that Peter Mladina in a recent paper shows that in a mean-variance framework where “triple net returns” or returns after all expenses, taxes and inflation are taken into account the recommendations for taxable investors are pretty clear cut. The pursuit of alpha in its various forms takes a back seat to more basis vehicles. He concludes:
Our findings suggest that taxable investors should own primarily low cost, passive or semi-passively managed equities, REITs and municipal bonds. The results are similar for tax exempt investors, with low cost, passively managed taxable bonds replacing municipal bonds. The primary benefits of passive and semi-passive management are lower management fees and lower turnover (generating lower trading costs and lower taxes). The magnitude of these expenses is probably underappreciated by most investors, and lost in the noisy returns of the last ten years.
So even in a lost decade for stocks and year in which the S&P 500 is for all intents and purposes flat on the year taxes still matter. Expenses matter. Every investor’s goal is to generate real, after-tax returns. Market returns are guaranteed to no one as is alpha. Investors need to recognize that inflation, expenses and taxes are here to stay. Fortunately expenses and taxes are two things that we have some control over.
Items mentioned above:
Inflation is still the silent killer. (Abnormal Returns)
Taxes are more important than alpha. (Turnkey Analyst)
Active management. (World Beta)
Managing tax challenges. (iShares)
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