Active vs Passive: Ride the Bus, or Take an Uber? 

11.29.2023 The S&P gained nearly 20 per cent this year, so why does it feel like stocks have gone nowhere? That’s because we are in one of the narrowest markets in history. So far in 2023, nearly three-quarters of the S&P’s 503 constituents are trailing the Index. As of July, only three of the 11 economic sector groups – technology, energy, and telecom – had delivered returns that beat the blue-chip Index’s 3.1 per cent gain over the previous 12 months. To many, it feels like a bear market – no surprise when, as of this writing, two-thirds of the S&P 500 companies are trading more than 20 per cent below their all-time highs and nearly half are trading more than 30 per cent below their peaks.

Over the years, and especially now, US large caps have proven to be a difficult asset class for active managers. A recent study published by Standard & Poor’s underscores the problem. Among all large-cap funds, 74 per cent underperformed the S&P 500 over a three-year period ending in 2022, according to the S&P. Longer term, the news gets worse. Over the last 10 years, owning a top-quartile manager wasn’t enough to beat the market, in fact, more than 90 per cent failed to keep pace. Because the blue-chip Index is capitalization weighted, market-beating winners gain an increased share of the portfolio over time. That’s counterintuitive to most active managers, who favor cheaper stocks, tend to sell the winners when they’re perceived as too expensive, and focus on cheaper, smaller names. 

Taxes add another layer of complexity, and challenge. Individuals and families, unlike endowments and foundations, pay taxes, so after-tax results are more meaningful. Tax considerations represent another hurdle for active managers, one that they have historically had a difficult time surmounting. According to the S&P study, the incremental results worsen when taxes are taken into consideration. That’s because active managers tend to buy and sell, often generating capital gains tax liabilities, while passive index funds typically buy and hold, so their holders need only pay tax on dividends. Over the 10 years ending in 2022, 98 per cent of large-cap core managers underperformed the S&P 500’s after tax. While taxes have detracted about 0.4 per cent annually from Index performance, thanks to dividend income, the combination of dividend income and capital gains has eaten away between 1.2-2.0 per cent annually from actively managed mutual fund results. 

Bottom Line: Investors should draw several conclusions from these results: 

1. Passive, buy-and-hold portfolios are more efficient in both pre-tax and after-tax results, particularly among US large caps. 
2. Portfolio structure is an important consideration. From a tax perspective, mutual funds are inefficient. It’s like riding a bus: your investment journey depends on what other shareholders do. That’s because mutual funds must distribute capital gains annually to all shareholders, whether they’re active investors or long-term holders. Many funds that were forced to raise cash to meet shareholder distributions last year incurred capital gains. Those gains were distributed to all shareholders, requiring them to pay capital gains taxes in a year in which the market was off more than 18 per cent. Exchange-traded funds (ETFs) solve the phantom capital gains tax problem. ETFs are like taking an Uber, because they keep your investment journey more personalized. That’s because ETF holders are not required to pay capital gains taxes until they sell the fund, regardless of what goes on inside the underlying portfolio. The after-tax difference between ETFs and mutual funds is dramatic. Compare, for example, State Street’s S&P 500 mutual fund and ETF. The strategies are identical, but the after-tax returns are not. Between 2009 and 2022 the State Street S&P 500 mutual fund and ETF delivered a 12.1 per cent annualized pre-tax return. After adjusting for taxes, the ETF’s return slipped 0.5% to 11.6% while the after-tax performance of State Street’s mutual fund fell to 10.3%, nearly two per cent. 

Lastly, owning a separate account of large caps is like driving your own car.  That’s because separate accounts are the most tax efficient of all portfolio structures.  Like ETFs, holders only pay taxes on dividends received but incur capital gains taxes only when they sell at a gain.  The benefit of owning individual equities is holders can actively take losses which can be used to offset future gains either in the large cap portfolio or any other holding the investor owns.  Active loss harvesting can actually increase after-tax results.  Feel free to reach out to Cresset if you would like to learn more about our approach to after-tax investing.