WE STILL AREN’T THROUGH with these relentless rules of humble arithmetic, the logical, inevitable, and unyielding long-term penalties assessed against stock market participants by investment expenses, the powerful impact of inflation, counterproductive investor behavior, and fund industry promotion of untested and “hot” mutual funds. These practices have slashed the capital accumulated by mutual fund investors. The index fund has provided excellent protection from the penalty of nearly all of these hidden costs. (Of course, the index fund’s real returns were not exempt from the ravages of inflation, which impact all investments equally.)

But there is yet another cost—too often ignored—that slashes even further the net returns that investors actually receive. I’m referring to taxes—federal, state, and local income taxes.¹ And here again, the index fund garners a substantial edge. The fact is that most managed mutual funds are astonishingly tax-inefficient Why? Because of the short-term focus of their portfolio managers, who too often are frenetic traders of the stocks in the portfolios that they supervise.

Managed mutual funds are astonishingly tax-inefficient.

The portfolio turnover of the average actively managed equity fund, including both purchases and sales, now comes to 78 percent per year. (The “traditional” turnover rate—which includes only the lesser of purchases or sales—is 39 percent.) Industrywide, the average stock is held by the average active fund for an average of just 19 months. (Based on total assets, the average holding period is 31 months.) Hard as it is to imagine, from 1945 to 1965 the annual turnover rate of equity funds averaged just 16 percent, an average holding period of six years for the average stock in a fund portfolio. This huge increase in turnover and its attendant transaction costs have ill-served fund investors. But the baneful impact of excessive taxes that funds have passed through to their investors have made a bad situation worse.

This pattern of tax inefficiency for active managers seems destined to continue as long as (1) stocks rise and (2) fund managers continue their pattern of hyperactive trading. Let’s be clear: In an earlier era, most fund managers focused on long-term investment. Now they are too often focused on short-term speculation. The traditional index fund follows precisely the opposite policy—buying and holding “forever.” Its annual portfolio turnover has run in the range of 3 percent, resulting in transaction costs that are somewhere between infinitesimal and zero.

Bring on the data!

So let’s pick up where we left off a few chapters ago. Recall that the net annual return was 7.8 percent for the average equity fund over the past 25 years and 9.0 percent for the S&P 500 index fund. With the high portfolio turnover of actively managed funds, their taxable investors were subject to an estimated effective annual federal tax of 1.2 percentage points per year, or about 15 percent of their total pre-tax return. (State and local taxes would further balloon the figure.) Result: their after-tax annual return was cut to 6.6 percent.

Despite the higher returns that they earned, investors in the index fund were actually subjected to lower taxes, largely derived from their dividend income. The extremely low costs of index funds consume less dividend income relative to actively managed funds, resulting in higher dividend yields and, therefore, higher taxes on dividends.

In mid-2017, the dividend yield on a low-cost Standard & Poor’s 500 index fund totaled 2.0 percent, double the yield on the average actively managed equity fund. Federal taxes cost taxable investors in index funds about 0.45 percent per year, only about one-third of the 1.5 percent annual tax burden borne by investors in actively managed funds.

Given that active funds often distribute substantial short-term capital gains to their shareholders—which are taxed at higher ordinary income rates, not the lower long-term capital gains rate—investors in active funds face substantial tax burdens that index investors do not face.

Result: The average actively managed equity fund earned an annual after-tax return of 6.6 percent, compared to 8.6 percent for the index investor. Compounded, an initial 1991 investment of $10,000 generated a profit of $39,700 after taxes for the active funds, less than 60 percent of the $68,300 of accumulated growth in the index fund. The active fund lag: a loss to their investors of some $28,600.²

Fund returns are devastated by costs, adverse fund selections, bad timing, taxes, and inflation.

I hesitate to assign to any single one of these negative factors the responsibility for being “the straw that broke the camel’s back” of equity fund returns. But surely the final straws include (1) high costs (Chapters 4, 5, and 6), (2) adverse investor selections and counterproductive market timing (Chapter 7), and (3) taxes (Chapter 8). Whichever way one looks at it, the camel’s back is surely broken. But the very last straw, it turns out, is inflation.

Nominal returns versus real returns.

When we pay our fund costs in current dollars, year after year—and that’s exactly how we pay our fund expenses and our taxes on fund capital gains (often realized on a short-term basis, to boot)—and yet accumulate our assets only in real dollars, eroded by the relentless rise in the cost of living that has been embedded in our economy, the results are devastating.

It is truly remarkable—and hardly praiseworthy—that this devastation is so often ignored in the information that mutual funds provide to their investors.

A paradox: While the index fund is remarkably tax-efficient in managing capital gains, it turns out to be relatively tax-inefficient in distributing dividend income. Why? Because its rock-bottom costs mean that nearly all of the dividends paid on the stocks held by the low-cost index fund flow directly into the hands of the index fund’s shareholders.