Insights

When it comes to the investment returns earned in the investors hands, several costs have to be considered. Depending on the structure and investment vehicles used, the costs that an investor has to explicitly contend with include: i. fees and expenses charged by the manager, ii. transaction costs, including brokerage, entry loads, and exit loads, and iii. capital gains taxes.

Unless the investor is using a tax-exempt account or vehicle, capital gains taxes can be one of the most significant costs incurred against investment returns; at times, larger than the fee and expenses charged by investment management vehicles. In an article that appeared in the Journal of Portfolio Management [1], the authors found that taxes take a big bite out of the total performance even at very low levels of turnover.

The table below shows the impact of capital gains taxes on a taxable portfolio. We have demonstrated three scenarios for annual portfolio turnover of 10%, 25%, and 50%. Lastly, we have shown the tax impact of investing in portfolios like GMF and GSVF, wherein capital gain taxes only occur at the time of redemption by the investor.

Much as Jeffrey and Arnott observed in the article referenced above and what comes as a surprise to most investors, capital gains taxes indeed take a big bite out of the overall performance at very low annual turnover. Consider that at just 10% portfolio turnover, which is synonymous with an average holding period of 10 years, the impact of taxes is the largest. The terminal wealth, when compared to a no-capital gains tax option as represented by GMF/GSVF, declines from $558 to $468.

What it means is that investors and their advisors must take into account the impact of taxes on the overall investment returns.

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1 Is Your Alpha Big Enough to Cover Its Taxes?, RH Jeffrey & RD Arnott, 1993, Journal of Portfolio Management.