Keep what you make

No one likes to think about how much money goes to the taxman, but there’s no avoiding these thoughts at this time of year.

There are many elaborate ways to reduce tax liabilities. Here’s one simple one that has worked like clockwork for 19 years in a row, with essentially no effort required on the part of investors.

Happy 19th Birthday

The largest exchange traded fund (ETF), State Street’s SPDR S&P 500 (symbol SPY) debuted on 1/22/93, closing that day at $30.88.

Now trading at around $137, the fund has returned an annualized pre-tax return of 7.70 percent over its lifetime (through 12/30/2011). Of course the number that really matters is what you keep – the after-tax return. That figure is 7.14 percent. (source: State Street Global Advisors)

That’s what we call a “capture ratio” of 92 percent. In other words, if you owned the fund since 1993, you’ve kept 92 percent of what you made, even after the taxman took his share.  How is this possible?

No gains. No pain.

A lot has happened since 1993, but one thing hasn’t happened even once: a capital gains distribution from SPY.

A capital gain occurs when a fund manager sells stocks that have appreciated. This profit is distributed to shareholders who pay the capital gains tax – short or long term, based on how long the stocks were held by the fund.

If you’ve owned actively managed mutual funds, you know all about these capital gains distributions that are generally paid out late in the year. Active managers typically make many buy and sell decisions throughout the year, potentially triggering significant gains…even if the fund as a whole is having a mediocre or poor year.

Index ETFs like SPY, on the other hand, typically make far fewer trades, mostly to keep the funds’ holdings in line with the indices they track. The few gains created can often be offset by losses on other sold shares. For SPY, this has meant no gains distributed to shareholders for 19 years and counting.

No gains means no taxes on gains.

SPY does pay a dividend, currently approximately 1.88 percent, which is taxable.  But when you are able to defer taxes on appreciation and pay taxes only on dividends you can see how that 92% capture ratio happens.  (Read a more technical discussion on tax efficiency of ETFs)

It’s a mystery

Hoping to make this article a fair comparison I tried to get the annualized after-tax return for the largest active mutual fund, AGTHX, the $126 billion American Funds Growth Fund of America. American Funds was not able to provide me with the numbers (State Street did it easily with SPY), nor were independent providers like Schwab and Morningstar.

So how much of the AGTHX return did investors keep after taxes over a comparable 19 year period?  One can only guess. American Funds does provide the amount of distributions that were paid out, which totals $20.06. That’s $20 over 19 years on a fund that was at $12 in 1993 and is in the $33 range today. (source: www.

In other words, the majority of AGTHX’s appreciation in the period was taxable, some at short-term rates (taxed like ordinary income at up to 35 percent), some at long term rates (currently 15 percent).

Twice, AGTHX paid out per share gains – $4 in 2000 and $2 in 2007 – even though the fund value was flat in both years.  Few things are less satisfying than paying taxes on an investment that’s not performing.

It pays to pay attention

The point here is very simple.  As you pursue your goals, always look at after-tax returns, what you keep after fees and taxes. And just as importantly, make sure your advisor is doing the same. Pre-tax performance just doesn’t tell the whole story.

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This article may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.

Nothing in this article is intended to be or should be construed as individualized investment advice. All content is of a general nature. Individual investors should consult their investment adviser, accountant, and/or attorney for specifically tailored advice.

Any references to third-party data or opinions are listed for informational purposes only and have not been verified for accuracy by the Adviser. Adviser does not endorse the statements, services or performance of any third-party vendor without specifically assessing the suitability of a third-party to a client’s or a prospective client’s needs and objectives.

An investment cannot be made directly in an index. Not all ETFs are managed with tax-efficiency as a goal. The performance of SPY and AGTHX are shown for illustrative purposes. These securities may or may not be held in client accounts.

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