April 21, 2017
IRS headquarters, April 15th, is the place in America where fun surely goes to die. As ground zero for tax collections, not only does the IRS finance the government, it provides endless fodder for political debate. Taxes are an enjoyable topic because there is rarely disagreement over the issue. :)
As long as we live in a civilized society, or at least semi-civilized, taxes will be part of investing. It is a broad area, so I am going to focus on two matters: reporting of investment returns with relation to taxes, and how tax-deferred index fund float benefits you as an investor.
Last newsletter I mentioned that the average actively managed mutual fund creates a tax headwind per year that averages 1% of your assets in a taxable account, which computes to reducing your net worth by 25% over time. Mutual funds, hedge funds, private equity funds, and other investment vehicles don't report their returns after tax. They pass the tax through to you as the investor, generally as part of Form 1099 that arrives from your brokerage house, and you pay the taxes for their activity on your personal return.
The average actively managed mutual fund turns over its positions 85% every year, and many turn over more than 100%. This is particularly bad because it triggers short term capital gains rates for investors.
Try buying a bagel tomorrow morning and handing the store owner your Form 1099, and suggesting they book the sale with pre-tax money. You'll have a hungry morning. What matters is how you do after-tax, and if active mutual funds reported after-tax numbers, they would compare *much* less favorably against index funds.
The reason is that well-constructed index funds rarely, if ever, pass through a recognized capital gain. Part of this is because they don't trade much. But they also have internal tax optimization strategies to offset gains they do recognize. I have spent hours on the phone with fund companies, trying to understand how they are doing this inside the funds. Here are three takeaways: 1. It is very complicated 2. They consider their strategies proprietary, and they don't like people asking questions 3. I say "well-constructed" above because there can be a large difference in tax efficiency between two index funds that otherwise appear similar.
This capital gain tax deferment as an investor is critical. It creates a form of personal "float" for you, and allows you to use money that would have otherwise been paid to the government to make yourself more money. This effect compounds over time in a mathematically exponential way.
Smart corporations use float all the time. That Starbucks card in your wallet, plus all the other Starbucks cards, is more than a pretty piece of plastic. It's generating almost $1.5 billion of float that Starbucks then invests. It owes you goods like Unicorn Frappuccinos on the payment, but in the meantime, it invests the money and doesn't pay you interest. The savings account that pays you effectively nothing at the local bank - you are giving the bank float for free. That insurance check you send every month? The insurer will eventually have to pay that money back to someone, but in the ensuing years in invests it and makes profits on the capital. Berkshire Hathaway, Warren Buffett's company, increased its insurance float form $19 million in 1967 to $92 billion today.
The key with float is to pay as little as possible for it. (Insurers go bankrupt all the time for ignoring this rule.) In our case with index funds, the tax deferment costs us nothing. We preserve the capital gain and intend to use it in perpetuity, or at least for a very long time, without paying anything for it.
An area where we do a lot of work at One Day In July is how to perfectly preserve float while also maintaining the ideal asset model. Accomplishing these two objectives simultaneously is somewhat more difficult.
Some of you may be thinking "but, isn't float just leverage, and isn't leverage dangerous?" The answers to those questions are a yes, and it depends. Tax-deferred index fund float is a form of leverage - you are using other people's money to make you money. But it has nowhere near the risk of traditional leverage, where you borrow other people's money, but you may have to give it back when they demand it (in fact, for many One Day In July clients, they'll *never* give it back to the U.S. Treasury, but that gets into estate planning / charitable giving topics). Normal leverage is dangerous, and we don't use it.
Index fund float costs nothing, and there is no "call" provision on it. This means someone cannot demand it back at a time of their choosing, leaving you in a bad position. What can happen: in a financial crisis, people may lose their jobs and have to call, or redeem, their own position. This creates an unexpected tax bill at precisely the worst time, both in terms of cash flow and for their future returns. In almost all client accounts there are positions that we have in place to hedge off this risk. It's a low probability event, but this is the kind of fun thing Hans and I think about.
Taxes. Float. Take a deep breath, you're ready for the weekend.