Promoters of index funds and exchange-traded funds (ETFs) often argue that their investments are far more tax-efficient than active funds. But that’s just an accounting illusion created by reporting mutual fund returns as if no capital-gains taxes would ever be imposed. The illusion would be dispelled if President Trump succeeds in eliminating the step-up in basis for securities in an estate.
The SEC requires that funds report after-tax fund returns using both the pre-liquidation and post-liquidation methods and gives funds latitude on which to emphasize in marketing literature. Index funds tend to emphasize returns calculated using the pre-liquidation method, because it makes them look better.
The pre-liquidation method assumes that the investor continues to hold fund shares at the end of the measurement period. In this method of reporting, after-tax returns are net of taxable distributions by the fund to its shareholders of dividends and capital gains realized through trading—but not of the capital gains taxes the investor will pay upon liquidation, as the Display below shows.
The post-liquidation method shows after-tax returns net of both distributions and the capital-gains taxes due upon liquidation. It more accurately reflects return after all taxes over the life of an investment.
Index funds trade very little, so their realized capital gains are very low. Actively managed funds trade more (sometimes, much more), so their realized gains are higher.
But most shareholders eventually sell their investments—and when they do, they have to pay taxes on the embedded capital gains. Because index funds don’t trade much, embedded gains tend to build to much higher levels over time. By contrast, the capital gains that actively managed funds distribute reduce the capital-gains taxes paid upon the eventual liquidation of the investment almost one for one.
The Display also shows that an active portfolio and a passive portfolio with the same pretax return can have the same post-liquidation returns after taxes, over relatively short periods, such as one year. Over longer time periods, passive portfolios get a slight return benefit from deferring taxes. We estimate that active portfolios need to return as little as 0.2% more per year after fees to make up for paying taxes earlier.
The one good argument for the pre-liquidation method has been that some investors intend to hold on to their portfolios until they die. At that point, the cost basis of their investments steps up to market value. While the heirs may owe estate tax on total assets above the applicable exclusion, they don’t pay taxes on the growth in the fund value from its original cost.
The Trump tax proposal would eliminate both estate tax and the step-up in cost basis to market value upon death. It’s conceivable the heirs will hold the investment, but if the money is ever going to be useful to them, they will need to liquidate some or all of the portfolio—and pay capital-gains taxes as a result. At this point, any tax deferral ends, and it becomes essential to measure after-tax returns on a post-liquidation basis.
The views expressed herein do not constitute, and should not be considered to be, legal or tax advice. the tax rules are complicated, and their impact on a particular individual may differ depending on the individual’s specific circumstances. please consult with your legal or tax advisor regarding your specific situation.
Article by Paul Robertson, Alliance Bernstein