June 3, 2019 Written by Bruce Paulson, CPA, JD, CFP ®, Senior Client Advisor
It is no secret: many active equity managers have a difficult time performing better than average when measured over full market cycles. Higher fees alone pose a performance hurdle for active managers, especially as the cost for passive equity exposure nosedives to near zero.
A lesser known and oft-misunderstood hurdle merits mention: taxes – those caused by active manager trading and striving to do better than some pre-tax benchmark.
Li’l Abner & Taxes: Buffett Parable
Mr. Buffett’s Li’l Abner parable in his 1993 letter to shareholders comes to mind. Mr. Buffett writes:
“…Tax-paying investors will realize a far, far greater sum from a single investment that compounds internally at a given rate than from a succession of investments compounding at the same rate…”
An example may be helpful. You invest $1,000,000 in ABC Corporation, trading at 15x earnings. It reinvests 80% of its free cash flow in the business and pays out 20% of free cash flow to shareholders (through dividends and share redemption). It generates 15% return on equity and the price-to-earnings multiple does not change. Your personal tax rate is 33%. In one case, you sit on ABC for 20 years; in the other, you trade ABC stock every year and pay tax. While both may be extreme examples, the charts below show the power of deferring income tax:
Net After-Tax Arithmetic
Another example may help. Imagine four different equity products or choices, with the lowest cost option (SP 500 ETF) costing .05% and returning 8%. Using reasonable assumptions, look at the numbers as you move from left (least expensive: lowest tax generating) to right (more expensive: higher tax generating active manager, hedge fund, or hedge fund of fund). The purple bar shows what higher gross return each more expensive choice (using same assumptions) must generate to equal 7.6% net after-tax return from SP 500 ETF.
So, back to the question: What higher net after-tax return must an active manager provide to outperform a lower cost, separate account, passive equity solution? Here is a reasonable, if not conservative, estimate:
There is always a well-known solution to every human problem – neat, plausible, and wrong.
H.L. Mencken, American journalist.
Mencken is right. There is no single active manager-fund hurdle. It depends on facts, comparisons, and choices (one being, how to capture equity index exposure). Whether tax loss harvests are permanent or temporary, tax savings matter as well (and is beyond scope of this discussion). All said, controlling the tax cost of investing often matters far more than investors may realize, especially for families who can defer paying income taxes out over many years (sometimes permanently).
The MRA Associates team welcomes your questions and comments.
Note: The numbers assume hedge fund fees are not tax deductible (meaning, they do not quality as so-called “trader expenses” under the Internal Revenue Code). If they do qualify as trader expenses, they would be tax deductible at the partnership level and increase the hedge fund (and fund of hedge fund) net after tax returns.
 Your author notes relative outperformance to a fully invested benchmark index is (or is not) the same sole measure of value-add by an investment manager, advisor, or both. Pros and cons exist with any investment decision, which is a conversation beyond the scope of this memo.
 See Exhibit A.
 What tax loss harvesting is worth depends upon several factors, including how you measure it (pre or post liquidation). Please see the following for details: https://www.mraassociates.com/do-tax-harvesting-solutions-deserve-a-place-in-your-passive-or-active-portfolio.. There are many articles and studies on tax loss harvesting, which we are pleased to share with you to support the row c estimate and for your general information.