When “Tax Efficiency” Means Lower Investor Returns
Marketing jargon can make this term mean a lot of different things. Here’s the right way to consider tax efficiency when selecting portfolio funds.
Tax efficiency can be an umbrella term that means a number of different things with investments.
Remember, the most important part of tax efficiency is what you earn after paying taxes—not before.
Should you always do the most ‘efficient’ thing? You’ll probably be surprised to hear this from me, but… no, you shouldn’t.
Consider the case of car fuel efficiency. Automatic, a company that helps drivers measure their own fuel efficiency, has found that speeds between 40 and 60 miles per hour is the ‘sweet spot’ of fuel economy for most cars. Does that mean you should always drive at 40 to 60 miles per hour? Of course not. Sometimes it’s safer to drive slower, and sometimes it’s important to drive faster. Fuel efficiency is just one factor to consider when deciding how fast to drive.
Now, let’s think about efficiency as it applies to investments. In financial marketing lingo, ‘tax efficiency’ is often bantered about as a great selling point for ETFs and fund products. The trouble is that while more efficient is usually better than less efficient, some financial marketers out there sometimes forget to tell you the whole story.
There are three types of tax efficiency an investor should know about before buying any fund, and they’re entirely different.
The Tax Efficiency Ratio
The first one is called the tax efficiency ratio. It’s a simple equation—pre-tax return divided by after-tax return—that just shows how much of the pre-tax return an investor keeps after paying taxes.
The reason why this can get a bit dubious is that, rather than learning the tax efficiency ratio, an investor really should just want to know the after-tax return, what goes in his or her pocket.
Sometimes, when that number is not as favorable as it should be, usually because of high management fees, talking about the tax efficiency ratio can be a good way to distract an investor from asking the right question: What are the management expenses?
In the following hypothetical example, two ETFs are shown, side-by-side. The first is a lower-expense ETF and the second is a higher-expense ETF. Both generated an average return of 8.5%, but the first had a management expense of 0.25% and the second had 0.50%.
The pre-tax return of the lower expense ETF was 8.25%, minus a 1.24% tax cost, equivalent to a 15% tax rate, giving the investor a net after-tax return of 7.01%.
The pre-tax return of the higher expense ETF was 8.0%, minus a 1.20% tax cost, also equivalent to a 15% tax rate, giving the investor a net after-tax return of 6.80%.
Yes, the first ETF has a ‘tax cost’ of 1.24% which is higher than the second ETF’s 1.20%, but the important number—the after-tax return—is also higher.
Interestingly, in both cases, the tax efficiency ratio—pre-tax return / after-tax return—is 85%. But, it’s the fund with lower expenses that offers a greater total return to the investor.
For many years, financial marketing actually focused on pre-tax returns because most money managers catered to the pension fund industry, which is tax-exempt. Managers who also focus on 401(k) plans that many employers offer for retirement also never worried about tax implications as those assets are also tax exempt, until withdrawal.
But today’s investors should pay attention to taxes—that is, after-tax returns.
Side-By-Side Comparison of Hypothetical Investments
|ETF A||ETF B|
|Return Before Expenses||8.50%||8.50%|
|Return After Expenses (Pre-Tax)||8.25%||8.00%|
|Net Investor Return (After-Tax)||7.01%||6.80%|
|Tax Efficiency Ratio||85%||85%|
|Investor Return Ratio||83%||80%|
A “Tax-Efficient” Structure
The second time an investor might hear about tax efficiency is within the structure of a fund, mutual funds, especially. The example case here is that an active portfolio manager is aiming for the highest possible return for all of the participants, not looking out for any individual investors and their tax status, and often trades without regard for the tax implications. Every time a mutual fund sells a component for a gain, it books a tax expense. The more profitable trading, the more potential tax expense.
Since most active managers underperform after fees and expenses, we don’t use funds that churn their holdings. In fact, we do the opposite. We tax loss harvest. Betterment’s Tax Loss Harvesting+ is part of our algorithm that sells positions with losses that offset the tax implications of external gains.
You can also use these tax losses inside your portfolio to offset up to $3,000 in income taxes each year. In an example featured in Betterment’s white paper on the subject, an investor could add 0.77% to an after-tax return via Tax Loss Harvesting+.² You should read and understand the white paper and discuss your specific situation with your tax professional to determine if TLH+ is right for you.
A “Tax-Efficient” Classification
A third case of talking about tax efficiency could be when learning about the different types of ETFs and their classifications, some of which come with much higher taxes.
ETFs, in general, have very favorable tax treatment for capital gains. The long-term capital gain rate of 15% is applied for positions held for at least one year.³ But some ETFs have different, and often less efficient, tax treatment.
For example, currency ETFs are structured as trusts with tax liabilities that get passed to shareholders, meaning profits are taxable as ordinary income. Metals ETFs, including gold and silver, are usually treated as collectibles, and subject to a maximum tax rate of 28%; while Futures Contract ETFs are taxed based on unrealized gains at the end of the year, with gains split 60-40 between the long-term and the short-term rates.
Tax efficiency is important, and we use it at Betterment to talk about our own portfolio. But, when contemplating any new investment, it’s important to focus on the after-tax returns, take advantage of tax loss harvesting, and read the fine print about different tax treatments for different investments.
More from Betterment:
- This Why An ETF Portfolio Serves You Better
- Is Smart Beta Just “Expensive” Beta?
- How to Make a Tax-Smart Investment Switch
¹ Tax cost is the difference between the pre-tax and after-tax returns and reflect the amount of return the investor paid in taxes. Tax-efficiency ratio is the percentage that the after-tax return represents of the pre-tax return.
² The potential after-tax benefit of TLH+ was calculated through historical backtesting of the strategy as applied to the Betterment model portfolio and is not based on actual client trading history, with all relevant assumptions stated within the text. Actual Betterment clients may experience different results. Factors which will determine the actual benefit of TLH+ include, but are not limited to, market performance, the size of the portfolio, the stock exposure of the portfolio, the frequency and size of deposits into the portfolio, the availability of capital gains and income which can be offset by losses harvested, the tax rates applicable to the investor in a given tax year and in future years, the extent to which relevant assets in the portfolio are donated to charity or bequeathed to heirs, and the time elapsed before liquidation of any assets that are not disposed of in this manner.
The backtesting analysis that produced this estimate was done over the 13-year period from 2000 to 2013. No reliable data was available prior to 2000 that could adequately represent the performance of the full Betterment portfolio. The years in question featured a number of exceptional periods of market activity, and past performance is no guarantee of future results. The information used as the foundation for historical backtesting was compiled from third-party sources, and while we believe the information provided here is reliable, we do not warrant its accuracy or completeness. Read more on how we backtest against historical data.
Tax loss harvesting is not suitable for all investors. Nothing herein should be interpreted as tax advice, and Betterment does not represent in any manner that the tax consequences described herein will be obtained, or that any Betterment product will result in any particular tax consequence. Please consult your personal tax advisor as to whether TLH+ is a suitable strategy for you, given your particular circumstances. The tax consequences of tax loss harvesting are complex and uncertain and may be challenged by the IRS. You and your tax advisor are responsible for how transactions conducted in your account are reported to the IRS on your personal tax return. Betterment assumes no responsibility for the tax consequences to any client of any transaction.
³ For those with salaries below $37,450, the long-term capital gains tax rate is now 0% and for people in the highest 39.6% tax bracket, it’s 20%.
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