Index or Active Managers - It's all in after tax returns

Numerous bloggers out there blog about this. The argument over which is better. Active fund management or Passive fund management (otherwise known as index following). Interestingly enough, the mainstream media seems to stay out of this one, probably for fear of backlash from Financial Planners and large Dealer Groups who are sponsoring their publications. For the uninitiated here is a brief rundown.

Active fund management involves a fund manager actively monitoring a portfolio with the aim to outperform an index.

Passive fund management involves a fund manager simply monitoring their portfolio to ensure it replicates an index with the aim to generate a return as close to the index as possible.

Now the active fund managers charge relatively high fees due to the time and expertise involved in their work but promise to provide higher long term returns. The passive fund managers charge lower fees as all they are trying to do is replicate the index, not outperform it.

This issue that many people have (bloggers included) is that for the relatively high cost of active management, does it actually provide a better long term return, or are you better off just investing in the index for a better net of fee long term return.

My opinion is divided. I see value in both strategies. If you pick the right Active Manager, you can definitely receive better long term average returns than the index, however, if you pick the wrong Active Manager you can end up performing worse than the index, and pay high fees for the pleasure of it! Start diversifying across fund managers to 'lower your risk' and you end up with some outperforming and some underperforming, leaving you with a net return of the index less management fees.

However, the issue isn't this complicated. You see, when comparing these returns, apples must be compared with apples. It's one thing to quote a certain return, however, if the investor is going to be liable to pay more tax on generating this return, then the 'net benefit' is not what is being quoted. It's like earning $100,000US in the United States, or earning $100,000US in Dubai. You're earning the same income, but you're going to be better off in Dubai where there is no income tax (and you get to ski on indoor snow and have servants at your beck and call).

This might be easiest to explain with an example.

Lets say your index fund has a return of 'X'. Of this return, 20% is returned to you in distributions, such as dividends and realised capital gains. You're actively managed funds generates a return of 'Y'. Of this return 50% is returned to you in distributions. Given that an active fund is constantly being analysed, stocks are being bought and sold based on feelings of whether it will go up or down, you would expect that more capital gains will be realised by the active fund.

I've gone to the liberty of researching average 5 year returns for a large Actively Managed Australian Share Fund and a large Index Australian Share Fund. To be fair, I've taken 6 active funds and taken an average return of the lot from VanEyk. The funds chosen are the flagship Australian Share Funds from AMP, Barclays, BT, Challenger and Colonial First State. The index fund I have chosen is run by Vanguard. I have not bothered averaging out returns for index funds as it would be expected that they would have similar returns.

Here's what I came out with.

Fund	Income (%)	Growth (%)	Total (%)
Barclays	12.85	3.49	16.34
BT	3.53	12.15	15.68
CFS	10.2	5.97	16.17
Challenger	9.37	8.01	17.38
AMP	9.77	5.05	14.82
Average	9.144	6.934	16.078

Index Fund

Growth: 10.73%
Income: 4.49%
Total: 15.22%

Well, between these 5 funds, we have outperformance of the index fund of 0.86% pa. Barclays, BT, CFS and Challenger have all outperformed the index, but AMP has underperformed. Good for you Mr Fund Managers!! However, 57% of the return has been distributed as income, compared to 30% on the index fund. I'm going to assume that the 4.49% income on the index fund is all dividends (in reality there will be some capital gain) and the 9.14% income on the active fund is made up of 4.49% dividends and 4.65% capital gains. For simplicity I will say that ALL of the capital gains are on assets held for more than 12 months, therefore are entitled to the 50% discount (in reality, not all will be held for that long).

Therefore, after tax return, assuming a marginal tax rate of 31.5% (which applies to most people with taxable income between $25,000 and $75,000) gives a return as follows:

Active Funds - 13.93%
Index Fund - 13.81%

The 0.86% per annum out performance has all of a sudden eroded to 0.12% per annum. This doesn't leave a lot of room for underperformance!

As Tim Shaw once said, "but wait, there's still more!".

The fund managers, after much criticism of late regarding these after tax returns have hit back. They have said, hang on a minute, you're only looking at returns whilst you are invested in the fund. By providing you with part of your capital back every year, we are helping you by spreading the capital gain out over the life of the investment, so you don't get hit with it all when you exit the investment at the end.

This argument is fine, apart from a few issues.

1. How much of the gain is being distributed with 12 months, where there is no 50% discount for capital gains? If the fund manager is buying and selling within a 12 month window, the investor is missing out on this 12 month exemption.

2. Many long term investors plan the sale of their taxable assets in years when their income is lower. They don't need you, Mr Fund manager to help them decide when is the best time for them to pay tax.

3. Gains are being duplicated. Whilst a stock may be held for the 12 months mentioned in point 1, there still must be some duplication of gains where they are realised over and over again. Eg, sell stock on a high, share price drops, rebuy, sell on high, etc. Multiple gains are being realised here.

The index vs active management debate is something I will address more often. I believe that there is a place for both. I actually have money invested in active funds and am happy with the returns I have received, although come tax time this year I'm sure I will do my usual round of complaining.

Something interesting I found whilst researching for this entry, from the funds I have compared here, the one year returns for the active funds and index fund are:

	Active	Index
Income (%)	18.92	6.65
Growth (%)	3.28	15.45
Total (%)	22.2	22.1

Using the assumptions used above, this is an after tax return of the active options of 18.17% and the index options of 20.01%.

Time to start finding some tax deductions I think!!!