Tax Efficiency of Active Strategies

April 15, 2011

Subscriber Question:

If I follow an active trading strategy like Upgrading, won’t I incur higher taxes?

NoLoad FundX Answer:

Although Upgrading is an active investment strategy, with turnover averaging over 100% annually, it has proved to be surprisingly tax efficient.

One of the great investment myths is that higher turnover automatically means higher taxes. Portfolio turnover, or the frequency of trading, is just one of many factors that determine total return. For example, with Upgrading, the positions we hold for only a few months are generally not big gainers, and in fact, some wind up as losses. Remember, we only sell our lowest ranking holdings. In a strategy like Upgrading, higher turnover often means realizing losses or relatively small gains. Our best holdings are generally held longer than a year, and when those gains are realized, they are passed along as long-term gains.

A 2014 study of momentum investing strategies like Upgrading confirmed this. It found “momentum actually has turnover that is biased to be tax advantageous—it tends to hold on to winners and sell losers—thus avoiding realizing short-term capital gains in favor of long-term capital gains and realizing short-term capital losses.”

We’ve compared the pre-tax and post-tax returns of NoLoad FundX’s recommended portfolio, the Monthly Upgrader Portfolio (MUP) with the Vanguard 500 Index Fund (VFINX), a “classic” buy-and-hold investment, and on both a pre-tax and after-tax basis, the MUP was superior to that of VFINX.

When returns of an active portfolio like the MUP are roughly the same as those of a passive portfolio like an index fund, the passive portfolio will beat the active portfolio on an after-tax basis. But when an active approach adds value over time, that extra return can more than offset the taxes that must be paid on realized gains – and that’s what we’ve seen with the MUP from December 31, 2000 through December 31, 2013

MUPaftertax

To calculate after-tax returns, we assumed reinvestment of the after-tax dividends and a complete liquidation of both portfolios. Our calculations assume a maximum federal tax rate of 36% on short-term capital gains and income, and a 20% rate on long-term capital gains prior to May 2003 and 15% after that date.

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