Why Index Funds Have Tax Advantages
April 04, 2019

Why Index Funds Have Tax Advantages

Investing in index funds is a lot like fishing. You drag a net around a lake. You sit back in your boat, enjoy a nice drink and you can sell what you catch.

Investing in actively managed funds is much the same. But you hire a few scuba divers to swim around your net. They try to corral the fish. Before you pay the divers, things might look good. But after expenses, this industrious approach usually comes up short.

This isn’t the case with index funds. They charge low fees, so they beat about 80 percent of actively managed funds. Still, plenty of investors still like to roll the active dice with actively managed funds. In a tax-deferred account, they face long odds. In a taxable account, such odds stretch even longer.

If you’re a really big saver, this is important to understand. After all, big savers often maximize contributions to their tax-deferred accounts, such as IRAs and 401(k)s. They require a taxable account if they want to invest more. In such accounts, index funds are far more efficient than actively managed funds.

Here’s how it works: Actively managed funds have active traders at their helms. They try to buy what’s hot and avoid what’s not. But if they buy a stock for their fund and then sell it at a profit, the fund’s investors have to pay capital gains tax. However, there are two types of capital gains tax: short-term and long-term. The short-term rate is applied when managers sell at a profit within a 12-month period. The long-term rate applies when a profitable stock is sold after a 12-month holding period. Ideally, fund managers should try to avoid selling stocks before 12 months are up. After all, the short-term capital gains tax rate is much higher than the long-term capital gains tax rate.

But most fund managers do a lot of trading. This costs investors plenty. Consider the Ivy Small Cap Core A fund. According to Morningstar, its average turnover is 119 percent per year. That’s equal to all of its stocks being traded within a 12- month period.

In a taxable account, this fund would be a nightmare. Over the 15-year period ending February 28, 2019, the fund averaged a compound annual return of 8.04 percent. But Morningstar offers a nifty little tool. Not only does the fund rating company show the fund’s pre-tax return of 8.04 percent, it also estimates the fund’s after-tax return.

In this case, Morningstar estimates the after-tax return at 5.77 percent. In other words, investors give up almost 29 percent, when combining short-term capital gains and dividend taxes.

By contrast, index funds are passive. They don’t frequently trade stocks, so they attract minimal short-term capital gains tax.

Morningstar’s Michael Laske says the average turnover ratio for actively managed domestic stock market funds was 63 percent, as of Feb. 28, 2019. Actively managed funds with high stock turnover are like fishing nets with holes. But what about active managers who don’t trade a lot? That describes Vanguard’s actively managed funds. Their managers follow a disciplined approach. For example, Vanguard’s U.S. Growth Fund has an annual turnover of just 33 percent. Almost all of Vanguard’s actively managed funds have lower than average turnover.

But that doesn’t make them as good as index funds. Vanguard’s Total Stock Market Index, for example, has an annual turnover rate of just 3 percent. That means far fewer holes in a taxable account.

Plenty of Vanguard’s actively managed funds have an index fund counterpart. I compared those with 15-year track records to their benchmark index funds. Returns were often similar before taxes took their bite. But taxes tore some really big holes.

For example, Vanguard’s actively managed Explorer Fund (VEXPX) is a small-cap growth fund. I compared its 15-year returns with Vanguard’s Small Cap Index Fund (VSMAX). Before adjusting for taxes, the compound annual returns were close: 9.01 percent for the actively managed fund versus 9.39 percent for the index. That gave the index fund a lead of 0.38 percent annually over 15 years.

But after estimated taxes, that gap grew wide. Vanguard’s actively managed Explorer Fund averaged a compound annual return of 7.48 percent. By comparison, Vanguard’s Small Cap Index averaged 8.98 percent. In other words, the index fund’s annual pre-tax advantage of 0.38 percent stretched to 1.50 percent in a taxable account.

That’s why, when it comes to investing, it’s best to keep things simple. It’s much like fishing with a massive net. We don’t need scuba divers to push fish into our nets. Such divers cost money–and they make bigger holes.

Index Funds Have Advantages After Tax
15-Year Returns - Ending February 28, 2019

Category Fund Pre-Tax Annual Return Annual Turnover Post-Tax Annual Return
U.S. Small Cap Stocks Vanguard Explorer (VEXPX) 9.01% 50% 7.48%
Vanguard Small Cap Index (VSMAX) 9.39% 15% 8.98%
U.S. Growth Vanguard U.S. Growth (VWUSX) 8.83% 33% 8.2%
Vanguard Growth Index (VIGRX) 8.89% 11% 8.61%
U.S. Value Vanguard Windsor (VWND) 6.89% 33% 5.72%
Vanguard U.S. Value (VUVLX) 6.88% 75% 5.80%
Vanguard Value Index (VIVAX) 7.9% 8% 7.33%
Health Care Vanguard Health Care (VGHCX) 10.86% 11% 9.24%
Vanguard Health Care Index (VHCIX) 10.02% 6% 9.71%
International Stock Vanguard International Explorer (VINEX) 7.41% 40% 6.13%
Vanguard International Index (VGTSX) 5.43% 3% 4.71%

Related Articles

This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

Performance data shown represents past performance. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown.

AssetBuilder Inc. is an investment advisor registered with the Securities and Exchange Commission. Consider the investment objectives, risks, and expenses carefully before investing.