Taxes, Investment Costs And Investment Returns
High before tax returns may not be best..
If you accept the often repeated warning that past investment returns do not provide a guide to future performance, you would be smart enough to not select a fund manager based simply on their recent results.
But what if you knew for certain (which you couldn't) that a particular investment manager would return 1% p.a. above their relevant market indicator, before investment costs and taxes, for the next 10 years. Would you select that manager in preference to one that guaranteed you the market return? As we demonstrate, not necessarily.
Your objective as an investor should be to maximise your investment returns after-tax, costs and inflation for the amount of risk you accept i.e. your net risk adjusted return. In this article, we will focus on the importance of taxes and investment costs (e.g. fund manager fees, transaction costs). We have discussed the risk issue extensively in our
Foundations of Financial Economics" articles and, excluding inflation indexed bonds, there is little an individual investor can do, directly, to take account of inflation.
Taxes and investment costs can severely reduce the amount of money that ends up in investors' pockets. Investment managers that are inefficient in the management of these components of your net risk adjusted return need to generate significant, reliable pre-tax and cost outperformance to compensate.
How tax structure, investment costs and the composition of investment returns interact
To examine how taxes and investment costs affect net investment returns, we assume an investment earns a before-tax, inflation and costs return or gross return of 9.2% p.a., for ten years. This happens to equal the return of the relevant market indicator for that type of investment i.e. it is "the market" return.
With inflation assumed at 4% p.a., an after inflation gross return of 5% p.a. is implied. Over ten years, $1,000 would grow to $1,629 in today's dollars. We will call this "gross real wealth". As we shall demonstrate, taxes and investment costs eat into gross real wealth to varying degrees.
As discussed in
by: John Raymond Leske
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