The Taxable Investor's Manifesto

CHAPTER EIGHTGet Value from Active Management

As we were reminded early in Chapter 4, over the long run, the odds are low of beating the market through active management of public equities, even before tax considerations. Nevertheless, it seems part of the human psyche that hope springs eternal that a smart manager can buy and sell stocks on a timely basis to generate above average returns.

Some active managers trade second to second; others may hold investments for years. Either way, after-tax success in active management is made harder by the fact that such activity creates tax drag. In fact, the very search for outperformance makes active management less efficient in taxable portfolios.

A colleague and I have done a detailed study asking this question: “How much value does an active equity manager need to generate just to match the performance of a broad-based index, net of tax?” The answer is that a manager must add an average of 1.5% to 2.5% of incremental performance above the index each year over two decades just to match the performance of their indexed benchmark. And that assumes the manager's net realized gains are all taxed at the lower long-term capital gains rate. We then studied the Morningstar database of active mutual funds to determine the likelihood of an active manager generating that much extra benefit. Based on history, the odds that any one actively managed mutual fund will match the performance of a comparable index fund over a 20-year time frame, net ...