Upgrading’s Surprisingly Tax Efficiency
Before & After Tax Returns of Monthly Upgrader Portfolio
When considering the tax efficiency of an investment
strategy, remember that your after-tax
returns are only better than your pre-tax returns
if you lose money. In other words, choosing a
strategy based solely on its implied tax-efficiency
may be hazardous to your financial health.
Upgrading is an active investment strategy,
with turnover averaging over 100% annually.
Nevertheless, it has proved to be surprisingly tax
efficient.
Higher Turnover Doesn’t Mean Higher Taxes
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.
Before & After Tax Returns
In the table below we compare the pre-tax and
post-tax returns of the MUP with the Vanguard
500 Index Fund (VFINX), a “classic” buy-andhold
investment. On both a pre-tax and after-tax
basis, the MUP was superior to that of VFINX.
The pre-tax 10-year annualized total return on the
MUP through the end of 2010 was 7.2%. After
taxes, that drops to 5.1%.
What’s more, because we treat the MUP as an
ongoing portfolio, the figures here do not reflect
significant realized losses that can be carried forward
into future tax years. As of December 31,
2010, the portfolio had a loss carry-forward equal
to approximately 20% of the portfolio’s ending
value.
