Deliberate tax management remains more of a niche than a standard practice. Despite the strategies outlined in Jeffrey and Arnott (Journal of Portfolio Management 1993), 25 years later many asset managers still fail to take advantage of them. By using the techniques listed in the earlier research, diligent practitioners can add value over many competitors relatively easily.

Turnover represents a major source of tax inefficiency. Notably, the first 10% of fund turnover in a taxable account can affect final wealth as much as the next 90%. And after 100% turnover, the tax basis, generally the cost basis of the portfolio, is always short term rather than long term, which means higher taxes on gains. Passive funds trade less than active funds, which tend to underperform after fees anyway, so by simply choosing passive (or smart beta) funds with low turnover, asset managers can hope to capture greater after-tax returns for clients.

The authors also survey more-recent (since 1993) products, such as smart beta, exchange-traded funds (ETFs), and exchange-traded notes (ETNs), which add to the tax management toolbox. True smart beta funds may offer tax management advantages because of their freedom from index-driven trades. The authors believe that smart beta also avoids overweighting overvalued stocks. If so, then selecting a smart beta fund will not only help reduce turnover but also introduce a value effect over time, which research has shown to offer outperformance over long time horizons. But the authors caution that some “smart beta” funds are active funds in disguise. ETFs and ETNs provide more-efficient structures for reducing capital gains taxes.

Using the Morningstar Direct database, the authors examine returns from 1993 through 2017 on more than 4,000 US equity mutual funds and ETFs, dividing them into categories for active, passive, factor, and smart beta. They rely on a keyword method to differentiate between the last two types (e.g., if “small cap” is in the name, it is a factor fund; if “equal weight” is in the name, it is smart beta).

The authors calculate four types of returns on the samples over 25 years of performance as well as over the last 10 years: gross of fees, net of fees, net of fees after taxes on distributions, and net of fees after taxes on distributions and liquidation. They examine the full sample and surviving funds for both periods, with additional consideration given to how fund style influences return—particularly because smart beta and the value factor are closely linked.

According to the authors’ estimate, over 25 years, surviving active funds have given up nearly 2.5% of return to taxes annually. Their regression results indicate that realized capital gains form the main driver of this tax burden, implying that deferring gains rather than realizing them through turnover would have the greatest effect on after-tax returns. Although reducing dividends further reduces the tax burden, doing so is not strongly recommended because high dividends often correlate with better performance. 

The authors present scatterplots comparing tax burden with gross return for both periods. Passive and smart beta funds appear similar in the 10-year period but show wide dispersion in the 25-year period. Thus, even passive managers must watch taxes.

It is surprising that asset managers have failed to take advantage of tax-reducing strategies to a greater extent in recent decades. At the mutual fund level, there may be the excuse that fund holders often use such tax-advantaged accounts as 401Ks and IRAs, and thus tax management offers little benefit. But a private wealth manager would be remiss not to watch capital gains timing and asset location as well as select, where appropriate, funds that limit tax exposure, such as municipal bond funds.

Mutual fund managers should consider their taxable investor base and take such actions as holding investments for at least one year to avoid short-term gains, matching gains and losses, harvesting losses to carry forward, avoiding “buying dividends,” and even electing at the fund level to pass through foreign tax credits to the shareholder. Advisers often counsel clients to focus on costs they can control. A mutual fund that demonstrates greater tax awareness helps them do that efficiently.

Smart beta funds may or may not prove superior to other forms of value investing in the future. The authors would probably be the first to admit that smart beta structures capture the value effect. Attempts to build a better value mousetrap have met with mixed success, so a manager allocating to value should pay attention to universe coverage, costs, and tax exposure. Smart beta may indeed end up being the cheapest way to go, but there are low-cost value funds that do not suffer from the index-driven changes the authors describe.