About those damn taxes...

About those damn taxes…

Ahhh, tax time! The time when working Americans get to tally up everything they made in the previous year, hunt for every deduction possible, squeeze in contributions to tax advantaged investment accounts, and then figure out if Uncle Sam owes them money, or if it is them who will be cutting a check to the government. The joys of it all!

While the average American probably only considers taxes a few times a year (assuming they are not one of those people who stare at their pay stub every other week and fume about those taxes, like me), those who manage investments should ALWAYS be thinking about taxes.

Why is that? Because here in the US, the government treats investments that are held for different periods of time in different ways, and thus the after-tax returns – which are really the only type of returns that matter – can vary greatly depending on the average hold time of an investment..

To provide some context, investment gains and losses are considered “short term” if held for a year or less. Short term gains are taxed at an investor’s marginal tax rate (ordinary income tax rate) at the federal level and at the state level.

Investment gains and losses are considered “long term” if held for over a year. Long term gains are taxed at a favored tax rate at the federal level (usually 15%-20%) but still usually at the ordinary income tax rate at the state level.

Note: Everything in this article will apply to ordinary brokerage accounts. Some accounts such as 401ks and IRAs are tax advantaged, meaning that capital grows within those account types untaxed. Taxes are either paid before the contribution is made to the account or as distributions are taken from the account, but as the account grows, taxes are not levied on capital gains, meaning that capital gains are able to compound at a higher rate in tax sheltered accounts than they are in non-tax sheltered accounts. Bottom line – for tax advantaged accounts, absolute and risk-adjusted returns are really the only considerations that matter. For non-tax advantaged accounts, net-of-tax returns are just as important a consideration!

So perhaps just as much as the investments in an account matter, hold time matters. Let’s take a quick example. Say I buy a stock and sell it 365 days later, netting a before tax return of $10k. Let’s assume I am in the top tax bracket, I live in California, and this is for tax year 2017. My tax burden on this gain will be 39.6% (max federal tax bracket) + 13.3% (max California bracket) = 52.9% (ignoring the deduction for state income taxes). Congrats to me! The government made more off my trade than I did! I fork over $5,290 of my $10k gain to the government and I am left with $4,710. That’s depressing.

Now let’s say that I hold the stock for one more day and then sell it. I have now held the investment for over a year, so I qualify for the long term capital gains rate at the federal level. While I still owe 13.3% to California, instead of owing 39.6% to the feds, I owe *only* 20% to Uncle Sam. As such, my total tax burden is 20% (federal long term capital gains, max rate) + 13.3% (max California rate) = 33.3%. I fork over $3,330 to the government and I am left with $6,670 to keep. By holding for one extra day, my after-tax return is up over 40% relative to the short term trade.

Taxes matter, thus investment hold times matter!

Perhaps the most important aspect of this issue is that short term capital gains require taxes to be paid in the year they are earned, thus short term capital gains can be extremely destructive to the growth of an account because they reduce the effect of compounding within the account. This effect is especially pronounced over long hold times.

Let’s take a look at another example to illustrate the negative effect on compounding of an account with regards to short term capital gains. Say we have two investors – investor A and investor B. Both investors are high income earners living in California. This means that short term capital gains will be taxed at 39.6% and 13.3% at the federal and state levels, respectively (total tax burden of 52.9% for short term cap gains), while long term capital gains will be taxed at 20% and 13.3% (total tax burden of 33.3% for long term cap gains).

Investor A buys a fund that annualizes 9% a year over a 10 year period. He never rebalances the fund and the fund never trades (impossible assumptions, I know, but we are using an extreme example here). As such, his account will compound at 9% per year and he will need to pay long term capital gains on the final gain when he takes a distribution at the end of the 10 year period.

Investor B invests in a fund that also happens to achieve a 9% annualized return. Investor B’s fund manager, however, is very active. He turns over the portfolio aggressively (trades a lot), and the fund’s 9% gain is treated as a 100% short term capital gain every year. As such, investor B needs to take money out of his account every year to pay taxes on that capital gain.

At the end of the 10 year period, how do investor B’s AFTER TAX returns compare to investor A’s? They are lower by about 0.5% annualized!

To go further down the rabbit hole, the effect of incurring short term versus long term gains will change drastically depending on your hold time! Let’s look at the exact same example as above, but instead of a 10 year period, let’s analyze over a 30 year period. So Investor A holds his low-turnover strategy for 30 years and doesn’t pay any taxes until the end of the hold period, while investor B pays short term capital gains every year for the 30 year time period…

Holy taxes! Over the longer time frame, the effect of taking taxes out of the account every year really has an effect! Investor A’s after tax rate of return is almost 2x that of Investor B’s. This is the effect of compounding. Since investor A doesn’t need to pay taxes until the end of his investment period, his capital base compounds to a much higher degree than investor B’s.

As an investor, it is important to not only manage the investments, but the tax burden as well. As an investment manager, if you aren’t managing to after-tax returns – you aren’t managing investments at all!

So how does a systematic trader think about taxes in relation to a trading strategy? Well, given that a systematic trader attempts to model future possibilities and probabilities as best as possible, a systematic trader will include taxes in their models!

So next time you are evaluating a mutual fund or next time you speak with an investment manager that is touting a strategy, make sure that you understand the tax consequences of the strategy and how it will affect the returns. You may just find that the after-tax returns are inferior to a benchmark or buy & hold strategy, even though the headline return numbers are impressive.

The moral of the story? You cannot only pay attention to headline returns. When evaluating a money manager or fund, you need to consider the tax consequences too. Consider strategies in light of where they fit within your portfolio as a whole, how the strategies blend with the other strategies in your portfolio (e.g. do they provide diversification of return streams amongst each other), and be sure to consider after commission, after fee, and after-tax returns.

And for God’s sake, max out your tax deferred accounts! The more money you can get into tax deferred accounts, the more ability you have to take advantage of high turnover strategies that have the potential to significantly outperform the market, but whose outperformance is significantly hindered outside of a tax-advantaged account.

Wait...is this an indictment of active strategies?

The short answer is no.

If you are considering an active strategy, make sure that the strategy has a solid, evidence-based foundation upon which it is built. Make certain that the strategy gives you a good chance of realizing superior after-tax returns relative to buy & hold.

Remember that time horizon matters. Depending on the investment horizon, an active strategy that has high turnover can potentially need to outperform buy & hold significantly on a pre-tax basis to still outperform on an after-tax basis. Remember that over longer term time horizons, high turnover strategies will need to have a higher degree of outperformance in pre-tax returns to offset the compounding benefit that low turnover strategies exhibit. For shorter term investment horizons (10 years or less, generally) the hurdle caused by realizing short term capital gains will be much, much lower to overcome, and a solid active strategy may be the right choice.

Consider allocating dollars in your tax advantaged accounts to your higher turnover strategies, while allocating dollars in your taxable accounts to more passive strategies.

And lastly, never forget that returns, even net-of-tax returns, should NEVER be considered in a vacuum. The return profile of a strategy always needs to be considered in light of the risk characteristics of that strategy, your individual risk tolerance, and how the strategy fits within your broader portfolio. The S&P 500 lost over 50% in 2008, and if you couldn’t hold through the drawdown, then your passive strategy became active very quickly!

Finance, investing, and trading are complex, and considering tax implications doesn’t do anything to reduce that complexity, but it is of paramount importance. Do your homework, do your diligence, or find a trustworthy fiduciary to help you with it.

More to come...