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Keeping What You Earn

The painful math of taxable accounts.

John Rekenthaler, 02/14/2014

The Big Picture
The paper's title caught me by surprise. "The 50% Rule: Keep More Profit in Your Wallet," by Stuart Lucas, chairman of the financial advisory firm Wealth Strategist Partners, advocates that investors retain at least half the profits generated in their taxable accounts, thereby giving less than half to government bodies and investment professionals. At first thought, the goal seemed very unambitious. With mutual fund expense ratios less than 1% for most large funds, investors surely need not leak anything like 50% of their profits.

It made sense on second thought. Percentage of investor profits, after all, is quite different from percentage of assets. A 1% annual expense ratio is a tiny fraction of overall assets, but in a year when market returns are 5%, that same expense ratio gobbles up 20% of gross profits. Also, Lucas incorporates tax effects. As he points out, performance is typically reported on a pretax basis. Pretax figures appear on fund advertisements, are shown in Morningstar performance tables, and are incorporated into the Morningstar Rating for funds. 

Taxes, of course, are not ignored by those who have the job of collecting them--and they are far from a minor effect in a taxable account, for investors in a high tax bracket. Indeed, for short-term capital gains and income, an investor in a high-tax state can surpass the 50% barrier on taxes alone. 

Unsurprisingly, Lucas touches only lightly on financial-advisory fees. They of course must also be added to the equation. As with fund expenses, the seemingly modest 1% of assets that are paid on a typical fee-based advisory account make up a much larger percentage of investor profits. 

How this all plays out can be seen in the graph below, taken from Lucas' article. I've chopped the lengthy footnotes, which give the various assumptions that go into the numbers. The picture's power lies in its two simple tales. One is that as gross returns decline, leakage as a percentage of profits rises. The other is that while index mutual funds retain more profits than actively managed funds, even actively run funds look good when compared with hedge funds and private equity funds. With those funds, it's very difficult to retain that seemingly low amount of 50%. 

  - source: Wealth Strategist Partners

Learning Points
One lesson, certainly, is to evaluate investments for taxable accounts--prospective and existing--on an aftertax basis. It's all very well for Fund A to have a higher pretax total return, or Sharpe ratio, or Morningstar star rating than Fund B, but if B is the superior fund after taxes are paid then it is the superior fund for the taxable account. 

(Lucas suggested in a conversation with me that Morningstar publish aftertax star ratings in addition to the current version. I don't think Morningstar would want two versions of the star rating floating around, but I certainly can see the need for tools that enable investors to make both total-return and risk/return comparisons between funds on an aftertax basis. The ability to incorporate other costs, for example, financial-advisory fees, would be helpful as well.)

is vice president of research for Morningstar.

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