People criticize active mutual funds for many reasons, some of which are debatable. But one argument that almost never comes up is this: how the impact on your portfolio of firing a manager after poor performance (and moving to a new fund) causes you to pay taxes earlier than necessary – leaving you less investment dollars for long-run compounding thereafter.
This can be easily seen by an example.
Suppose you and a sibling both inherit and invest $100,000 at age 28. Your sibling chooses a low-cost index fund or ETF, but you choose an active mutual fund. And let’s suppose the market as a whole (and a low-cost index fund) delivers 10% average annual returns. This means that the market will double every 7 years (roughly).
Perhaps in the first 3 years things go well: the active manager outperforms the index by a few percent, on average, with the final year coming up a bit short but still leaving you ahead of the index fund. But then things turn bad. For the next three years there is nothing but significant underperformance. At the end of seven years, your $100,000 has become $190,000, but your sibling’s investment is worth $200,000. Disappointed with the manager, you want to change funds: after all, there is no point paying active fees to underperform an index fund.
But this means that when you sell the $190,000 of mutual fund shares, you will owe taxes of perhaps $35,000 right away. The manager may have underperformed, but the rising tide of the market as a whole gave you $90,000 of gains that will be taxed now. Clearly most of the return you got came not from what the active manager did, but from what the market did. But it matters not how this happened: when you go to reinvest the proceeds with a new manager, you now have only $155,000 to reinvest since taxes “sliced” $35,000 from your portfolio.
So now, as you look forward, you are starting with a balance of $155,000 from having tried the active manager. But had you invested in the index fund like your sibling you would now have $200,000. Put another way, what you start with now is $45,000 less than it would be had you used the index fund from the start.
And here is the problem. Suppose you are 35 at this point. If the market keeps delivering roughly 10% annual returns and doubling roughly every 7 years, in 35 more years it will double 5 more times, which is equivalent to multiplying it by 32. So, at age 70, having experimented with the active manager means you are going to come up roughly $1.4 million short of what your sibling will get from having started with the index fund in the first place and sticking with it.
There are lots of reasons people raise against active management. But, surprisingly, few of them think of this issue at the portfolio level, and miss this very central point: the tax impact of changing managers is incredibly expensive over the long-haul (in this case, 140 times larger than the underperformance you already suffered).
Why does this get missed so often?
Because people focus too much on funds and fund performance in isolation. They don’t think clearly about how returns (after taxes) and compounding work in the long run at the portfolio level. Having to pay taxes early in a long-term investment program really chews into the final returns, as you can see.
If people have learned any investing theory, it has almost always been taught without considering taxes. This is probably because the largest investors in the market (like university endowments and pension funds) are tax-exempt – so the issue never comes up.
But if you are investing taxable money the answer is quite different. Every time you switch managers you pay a tax on the gains, most of which came from the market itself, not the manager – thus reducing the amount you could have had from starting with the index fund (and sticking with it).
Given this, why would anyone try using an active manager in a taxable account? If you are 35 and saving for retirement, you’d really have to believe that any active manager you choose will beat the market over at least 20 to 30 years, and by quite a bit – because if you get disappointed and fire the manager, you will immediately lose perhaps 35% or more of your investment gains to taxes, and that money will never compound further.