How Much Does Tax Erode Fund Excess Return

We model the tax drag from active funds management by simulating portfolios based on reported monthly holdings of 207 active Australian equity funds between July 2000 and December 2010, and then compare both pre-tax and after-tax fund returns versus those for passive indices modeled under the same assumptions. Tax drag erodes 65% of the 0.74% excess return in Broad Market funds, but only 21% of the 1.80% excess return in Small-Cap funds for Australian superannuation (pension) fund investors. We also find that tax drag varies with investment style; market state, and is most detrimental during bull markets; and fund turnover – although the relation between turnover and after-tax excess return is non-monotonic. For high-income individual investors, tax drag is exacerbated to the extent that active management only generates meaningful after-tax excess return for Small-Cap funds of certain styles. Our study highlights the importance of considering tax when choosing between active and passive funds management, as well as how tax impacts can vary according to the circumstances.