May 16th, 2014
The impact of fees on long-term performance is a common marketing theme among ETF and other low-fee providers.
It’s a valid consideration, because fees reduce total returns. But there’s another drag on performance that can have more impact: taxes.
A perfect world
What would happen in a world without taxes or fees? Let’s look at two different portfolios where income’s automatically reinvested:
Bonds: $100,000 growing at 6%
Stocks: $100,000 growing at 9% (6% capital appreciation, 3% dividend yield)
Over 20 years, each would grow as follows:
Let’s now consider the impact of two different fee scenarios: high and low.
Bond @ 1.80%: $227,695 ($93,018 total fee drag: 29%)
Equity @ 2.50%: $352,364 ($208,077 total fee drag: 37%)
Low (cut both fees in half):
Bond @ 0.90%: $270,429: ($50,284 total fee drag: 16%)
Equity @ 1.25%: $444,985: ($135,626 total fee drag: 21%)
Because of compounding, halving fees doesn’t halve fee drag. Even small differences in a compound rate over a period as long as 20 years create disproportionate results.
Now let’s look at fee drag versus tax drag. There are three tax rates we need to consider: interest, dividends and capital gains.
Tax drag on fixed income
Interest earned on fixed income is taxable annually at the same rate as regular income. Consider two scenarios: high tax (50%) and low tax (25%). (These are close approximations of the upper and lower tax rates in several provinces.)
50% tax: $180,611 ($140,102 total tax drag: 44%)
25% tax: $241,171 ($111,193 total tax drag: 32%)
With interest income, the tax drag on performance is substantially worse than fee drag. In every possible combination, tax has a larger impact than fees:
High Fee/High Tax: 29% versus 44%
High Fee/Low Tax: 29% versus 32%
Low Fee/High Tax: 16% versus 44%
Low Fee/Low Tax: 16% versus 32%
Tax drag on equity
Consider these five variables when looking at the impact of tax on equity investing:
capital appreciation rate;
capital gains tax rate;
dividend tax rate; and
portfolio turnover ratio.
Return on equities consists of capital appreciation and dividends. We assume the after-tax amount is reinvested, as well as 6% capital appreciation and a 3% dividend yield.
Capital gains are easy to approximate. Given they are 50% taxable, we can assume half the rate used for fixed income. That means 25% for the high rate and 12.5% for the low.
It’s less straightforward with dividend income. Due to how taxes on eligible dividends in Canada are calculated and the fact that rates vary across provinces, the marginal tax rate on dividends is actually negative. For this analysis, we’ll again consider two rates: a high rate (33%) and a low rate (0% rather than negative).
These four tax rates still only lead to two different outcomes. Since someone at a high rate pays that rate for capital gains and dividends, there’s no need to consider any high and low combinations.
Turnover ratio has a significant impact on taxation. It represents the percentage of the portfolio that’s sold off to buy new investments in a given year. This has a massive impact on capital gains tax, which is only payable in the year the investment’s liquidated. So, the lower the turnover ratio, the fewer times capital gains tax is paid. That means the investment’s return can compound for longer without tax.
We’ll consider only the extremes: buy-and-hold (turnover ratio of 0%) and a highly active strategy (turnover ratio of 100%).
High Turnover/High Tax: $353,027 ($207,414 total tax drag: 37%)
High Turnover/Low Tax: $488,155 ($72,286 total tax drag: 13%)
Low Turnover/High Tax: $398,241 ($162,200 total tax drag: 29%)
Low Turnover/Low Tax: $502,886 ($57,555 total tax drag: 10%)
Turnover has a greater impact than tax rates.
High-bracket, high-turnover investors suffer tax drag that’s roughly equivalent to what high-fee investors face.
High-bracket, low-turnover investors are better off than high-fee investors, and worse off than low-fee investors.
Low-bracket investors suffer more from fee drag than tax drag.
We may conclude that equity investors are less tax sensitive than fee sensitive, especially when compared to fixed-income investors. It’s also important to note that high turnover is relatively rare in the managed-product world. Assuming the average mutual fund turnover rate is around 33%, odds are most investors experience tax drag higher than 10% to 13%, but much lower than 29% to 37%.
This is a simplified example. If you ran a more exhaustive analysis, you’d find the crossover point where taxes are worse than fees.
There’s much discussion in the media about fee drag, but there are other costs a good advisor can (for a fee) help minimize through effective planning. From advice on sheltered accounts to tax loss selling, advisors can help minimize or eliminate long-term losses from tax drag.