Advantages in tax inefficient funds

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
Angelus359
Posts: 825
Joined: Tue Mar 04, 2014 12:56 am

Advantages in tax inefficient funds

Post by Angelus359 » Sat Mar 29, 2014 2:57 pm

As I preface most of my posts. I don't really know what I'm doing. I'm not really sure most of us do.

What I have read, in a few places, is that the market is efficient. One of the efficiencies of the market, includes having an accurate valuation of a fund, including tax costs.


I may be wrong, but would that implicate that tax inefficient equities (dividend producing) theoretically, should be worth more to someone who is storing the funds in a tax advantaged account, and less in a taxable account, as a greater percentage of their total return is less valuable to some people in the market, effectively increasing their total return for people who have the funds in non taxable accounts, relative to tax-efficient equities?

This is a similar concept to municipal bond funds having a higher effective yield than corporate, despite having lower actual yield.
IT-DevOps System Administrator

retiredjg
Posts: 31488
Joined: Thu Jan 10, 2008 12:56 pm

Re: Advantages in tax inefficient funds

Post by retiredjg » Sat Mar 29, 2014 3:39 pm

I didn't follow all of your wording, but here is some information that might answer your question.
  • You should not even be using a taxable account for retirement funds unless you have already filled up your tax-advantaged accounts (401k, IRA, etc.)

    If you find yourself using a taxable account for retirement money, you should put tax-efficient things there. Examples would be Total Stock Index and Total International Index. There are others, but they don't pay a lot out each year. If you want to hold REIT (pays distributions frequently) you would hold that in an IRA or other tax-advantaged account.
Does that help?

User avatar
Doc
Posts: 7854
Joined: Sat Feb 24, 2007 1:10 pm
Location: Two left turns from Larry

Re: Advantages in tax inefficient funds

Post by Doc » Sat Mar 29, 2014 4:01 pm

... theoretically, should be worth more to someone who is storing the funds in a tax advantaged account, and less in a taxable account, as a greater percentage of their total return is less valuable to some people in the market, effectively increasing their total return for people who have the funds in non taxable accounts, relative to tax-efficient equities?
In order to have the effect you are describing it would be necessary for the total capital in tax advantaged accounts to be large enough that by themselves they could affect the market. I would be very surprised if tax advantaged accounts made up enough of the market to make any difference.
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.

Angelus359
Posts: 825
Joined: Tue Mar 04, 2014 12:56 am

Re: Advantages in tax inefficient funds

Post by Angelus359 » Sat Mar 29, 2014 4:09 pm

Doc wrote:
In order to have the effect you are describing it would be necessary for the total capital in tax advantaged accounts to be large enough that by themselves they could affect the market. I would be very surprised if tax advantaged accounts made up enough of the market to make any difference.
Actually the reverse is true.

The smaller the % of total capital of a given stock is in a tax advantaged account, the more the advantage found, of buying the stock in a tax advantaged account becomes!

If 95% of a given stock is not tax-advantaged, and it pays a 4% dividend, and the average tax rate is... just for sake of easy numbers, lets say 25%, that means that 1% of the return is taxed away, which means that to 95% of investors, that stock has a total return of 1% less. That should be reflected in the price of the stock. That should bring a premium advantage to people who do place it into a tax advantaged account.

On the other hand, if tax advantaged accounts were used everywhere (obviously they're not), that premium would be a lot less.

Does this make sense?
IT-DevOps System Administrator

Sidney
Posts: 6652
Joined: Thu Mar 08, 2007 6:06 pm

Re: Advantages in tax inefficient funds

Post by Sidney » Sat Mar 29, 2014 4:12 pm

Doc wrote:I would be very surprised if tax advantaged accounts made up enough of the market to make any difference.
Given the size of pensions, endowments, foundations etc I woud not be surprised if tax advantaged were larger.
I always wanted to be a procrastinator.

Angelus359
Posts: 825
Joined: Tue Mar 04, 2014 12:56 am

Re: Advantages in tax inefficient funds

Post by Angelus359 » Sat Mar 29, 2014 4:20 pm

Sidney wrote:
Doc wrote:I would be very surprised if tax advantaged accounts made up enough of the market to make any difference.
Given the size of pensions, endowments, foundations etc I woud not be surprised if tax advantaged were larger.
I was thinking the same thing.

What I'm looking at should be a market advantage, but it shouldn't be a huge one.

Theoretically, I'd guess it to be

dividend rate * (1 - (capital in tax advantaged accounts / total capital))
IT-DevOps System Administrator

User avatar
bertilak
Posts: 5783
Joined: Tue Aug 02, 2011 5:23 pm
Location: East of the Pecos, West of the Mississippi

Re: Advantages in tax inefficient funds

Post by bertilak » Sat Mar 29, 2014 4:22 pm

Angelus359 wrote:
Doc wrote:
In order to have the effect you are describing it would be necessary for the total capital in tax advantaged accounts to be large enough that by themselves they could affect the market. I would be very surprised if tax advantaged accounts made up enough of the market to make any difference.
Actually the reverse is true.

The smaller the % of total capital of a given stock is in a tax advantaged account, the more the advantage found, of buying the stock in a tax advantaged account becomes!

If 95% of a given stock is not tax-advantaged, and it pays a 4% dividend, and the average tax rate is... just for sake of easy numbers, lets say 25%, that means that 1% of the return is taxed away, which means that to 95% of investors, that stock has a total return of 1% less. That should be reflected in the price of the stock. That should bring a premium advantage to people who do place it into a tax advantaged account.

On the other hand, if tax advantaged accounts were used everywhere (obviously they're not), that premium would be a lot less.

Does this make sense?
This has always made sense to me. The market prices are set based (in part) on tax consequences. If the consequences are less for you than for the average investor (which must be the case since not all investors have tax advantaged accounts) then you should have a slight advantage. Market prices are lowered by all those who need a "better deal" to make their tax loss worth the cost.

At least that seems like a reasonable idea.

I might be convinced otherwise by a line of argument saying that prices are set at the margin so my thoughts about "average" above are somehow off the mark. Since I haven't figured out how I personally would frame such an argument I have ignored the possibility!
Listen very carefully. I shall say this only once. (There! I've said it.)

Angelus359
Posts: 825
Joined: Tue Mar 04, 2014 12:56 am

Re: Advantages in tax inefficient funds

Post by Angelus359 » Sat Mar 29, 2014 4:30 pm

Okay, I'm glad I'm not the only one with this mindset.
IT-DevOps System Administrator

User avatar
wintermute
Posts: 179
Joined: Mon Mar 15, 2010 10:36 pm

Re: Advantages in tax inefficient funds

Post by wintermute » Sat Mar 29, 2014 5:10 pm

Angelus359 wrote:What I have read, in a few places, is that the market is efficient. One of the efficiencies of the market, includes having an accurate valuation of a fund, including tax costs.
The market tends towards efficiency, it's not an absolute. It takes the work of people to make it efficient.

I agree, tax cost should be included by rational, knowledgeable people when they consider a relative asset allocation (indexing) or the absolute price of an asset (trading for alpha). If enough money is sheltered from immediate taxes, by 401ks, IRAs, then the asset may be bid up to the point that you don't get any extra return by putting it in a retirement account, but instead it becomes a requirement, to earn the market's assumed forward looking return.

There's a flip side to this also. Holding high tax cost (or just high cost) funds in retirement accounts can be a conduit for transferring some of the tax benefit from the individual to others. e.g., 401k's where the providers' fees can eat up nearly all the tax benefit. Those providers are arbitraging away the tax benefit from participants to themselves.

Getting back to the allocation decisions, there's two possibilities:
a) asset is priced lower than others due to tax cost. You gain alpha by placing in tax deferred.
b) asset is priced only by its other factors, tax cost is in aggregate ignored by the market. You lose alpha unless held in tax deferred. This would happen if many other effective price setters are holding in tax deferred, forcing you to do the same.

So in all cases you should place high turnover, high yield assets in retirement accounts. You may or may not make extra that way.

Angelus359
Posts: 825
Joined: Tue Mar 04, 2014 12:56 am

Re: Advantages in tax inefficient funds

Post by Angelus359 » Sat Mar 29, 2014 6:17 pm

That makes a lot of sense.

I only invest in my vanguard Roth IRA so I'm set either way.
IT-DevOps System Administrator

Angelus359
Posts: 825
Joined: Tue Mar 04, 2014 12:56 am

Re: Advantages in tax inefficient funds

Post by Angelus359 » Sat Mar 29, 2014 6:33 pm

Just a thought. Wouldn't it be depending on actively traded volume instead of the volume simply stored.

Tax deferred volume typically is a buy and hold system which after initial purchase is held for a long time.

I heard a stat the other day that on average stocks are only held for 6 weeks, so I'm not sure
IT-DevOps System Administrator

User avatar
grabiner
Advisory Board
Posts: 21582
Joined: Tue Feb 20, 2007 11:58 pm
Location: Columbia, MD

Re: Advantages in tax inefficient funds

Post by grabiner » Sun Mar 30, 2014 10:30 am

Angelus359 wrote:As I preface most of my posts. I don't really know what I'm doing. I'm not really sure most of us do.

What I have read, in a few places, is that the market is efficient. One of the efficiencies of the market, includes having an accurate valuation of a fund, including tax costs.
Funds are valued at NAV, the value of their underlying holdings. The efficient market hypothesis assumes that these underlying holdings are fairly priced. (This is why high-turnover funds are bad investments in a taxable account; you pay the same price for a large-cap fund whether you lose 0.3% to taxes on an index fund or 1.5% to taxes on a fund which realizes a lot of short-term gains.)
I may be wrong, but would that implicate that tax inefficient equities (dividend producing) theoretically, should be worth more to someone who is storing the funds in a tax advantaged account, and less in a taxable account, as a greater percentage of their total return is less valuable to some people in the market, effectively increasing their total return for people who have the funds in non taxable accounts, relative to tax-efficient equities?
Most stocks held even by taxable investors are not held for long time periods. If you only hold a stock for two years, receiving income as a qualified dividend taxed now rather than as a capital gain taxed two years from now makes very little difference. And if you hold it for less than one year, receiving income as a qualified dividend taxed now rather than as a short-term capital gain taxed at a higher rate next year is actually better.

But varying tax rates on dividends would make a difference. A REIT and a utility stock might have the same dividend yield, but the REIT's dividend is non-qualified. A tax-exempt investor won't care, and will be willing to pay the same amount for both stocks; a taxable investor will prefer the utility stock. This might cause REITs to be slightly undervalued for tax-exempt investors. (And if it doesn't, then it must cause REITs to be significantly overvalued for taxable investors.)
David Grabiner

Angelus359
Posts: 825
Joined: Tue Mar 04, 2014 12:56 am

Re: Advantages in tax inefficient funds

Post by Angelus359 » Mon Mar 31, 2014 10:39 am

When I was talking about tax inefficiencies, I wasn't talking about the tax inefficiencies of a fund as a whole, but rather their underlying stocks.

For example, the dividend appreciation index has a slightly (very slightly) higher dividend rate than total stock market as the underlying stocks have a higher average dividend rate. That increases tax liabilities for ownership.

That tax liability could be a dis-incentive to owning the underlying securities in taxable.

You mention that the stocks aren't typically held for very long, but even if they are bought and sold, somebody is getting the dividend, and that somebody had to buy it, at a a price that would have be adjusted for the dividend existing.
IT-DevOps System Administrator

User avatar
Phineas J. Whoopee
Posts: 6918
Joined: Sun Dec 18, 2011 6:18 pm

Re: Advantages in tax inefficient funds

Post by Phineas J. Whoopee » Mon Mar 31, 2014 2:57 pm

Angelus359 wrote:...
What I have read, in a few places, is that the market is efficient. One of the efficiencies of the market, includes having an accurate valuation of a fund, including tax costs.
...
Sorry to disagree with you and others, but those assertions are not, nor can they be, correct, not even in principle.

Let's take the easier one first: taxation. Different investors have different tax costs, and value those costs differently. Many are institutions which are exempt from income tax. Others are institutions which incur income tax due by their investors, but are themselves compensated in such a way they're indifferent to that. Yet more are individuals with high marginal brackets for whom capital gains, at least, enjoy a tax break. Some are individuals with incomes low enough that capital gains are untaxed.

I don't know how anyone in their own individual situation can look at a market price and presume it's set for them in their own unique tax situation. All they can do is influence prices by deciding to buy, sell, or stand pat.

Now for the other: "an accurate valuation of a fund." What does that mean? Is it that dollars have an easily-determinable fundamental value, and funds do too, and dividing the latter by the first gives the right price? There's no such thing. Assuming we're talking about the U.S. we have token money, which isn't specifically convertible into any fixed amount of anything. In its store of value function it's a an unknown claim on unknown future economic production. It's nothing else.

The Efficient Market Hypothesis, and if you mean something other than that by your use of the word "efficiency" please correct me, posits markets are informationally efficient. It only posits because it's only a hypothesis. It makes good, testable predictions, but hasn't advanced to the level of a theory yet.

In its weak form it says you can't earn an outsized profit by exploiting information that's already widely disseminated (you know what everybody else already knows). I personally view that as trivially true.

In its semi-strong form it says you can't earn an outsized profit by exploiting newly-available information (you know what only a few other market participants who pay lots and lots of money on communications and computing infrastructure to receive, process, analyze, and act on new information really, really fast do). That's probably true up to a limit, and that limit is continually expressed by what firms are willing to spend to out-do each other on those capabilities, I think.

In its strong form it says you can't earn an outsized profit by exploiting inside information (you know what both corporate insiders and you are legally prohibited from trading on). I think that may be true, but only by virtue of the recent rash of convictions of traders for violating securities regulations.

If I've misunderstood you please both forgive and correct me.

PJW

Angelus359
Posts: 825
Joined: Tue Mar 04, 2014 12:56 am

Re: Advantages in tax inefficient funds

Post by Angelus359 » Mon Mar 31, 2014 5:57 pm

Phineas J. Whoopee wrote:
Angelus359 wrote:...
What I have read, in a few places, is that the market is efficient. One of the efficiencies of the market, includes having an accurate valuation of a fund, including tax costs.
...
Sorry to disagree with you and others, but those assertions are not, nor can they be, correct, not even in principle.

Let's take the easier one first: taxation. Different investors have different tax costs, and value those costs differently. Many are institutions which are exempt from income tax. Others are institutions which incur income tax due by their investors, but are themselves compensated in such a way they're indifferent to that. Yet more are individuals with high marginal brackets for whom capital gains, at least, enjoy a tax break. Some are individuals with incomes low enough that capital gains are untaxed.

I don't know how anyone in their own individual situation can look at a market price and presume it's set for them in their own unique tax situation. All they can do is influence prices by deciding to buy, sell, or stand pat.

Now for the other: "an accurate valuation of a fund." What does that mean? Is it that dollars have an easily-determinable fundamental value, and funds do too, and dividing the latter by the first gives the right price? There's no such thing. Assuming we're talking about the U.S. we have token money, which isn't specifically convertible into any fixed amount of anything. In its store of value function it's a an unknown claim on unknown future economic production. It's nothing else.

The Efficient Market Hypothesis, and if you mean something other than that by your use of the word "efficiency" please correct me, posits markets are informationally efficient. It only posits because it's only a hypothesis. It makes good, testable predictions, but hasn't advanced to the level of a theory yet.

In its weak form it says you can't earn an outsized profit by exploiting information that's already widely disseminated (you know what everybody else already knows). I personally view that as trivially true.

In its semi-strong form it says you can't earn an outsized profit by exploiting newly-available information (you know what only a few other market participants who pay lots and lots of money on communications and computing infrastructure to receive, process, analyze, and act on new information really, really fast do). That's probably true up to a limit, and that limit is continually expressed by what firms are willing to spend to out-do each other on those capabilities, I think.

In its strong form it says you can't earn an outsized profit by exploiting inside information (you know what both corporate insiders and you are legally prohibited from trading on). I think that may be true, but only by virtue of the recent rash of convictions of traders for violating securities regulations.

If I've misunderstood you please both forgive and correct me.

PJW

You actually did misunderstand a few points.

My definition of efficiency, in this regard is informational.

If a stock has a dividend, the stock loses capital, and distributes it to shareholders.
This is publicly available information, as to how much capital they lost.

The stock loses value, due to reduction in capital.

Total return is equal to price return + dividend return - taxes on dividend return.

The higher the dividend return, the higher the taxable segment can be.

Stocks that have a long history of paying solid dividends, will have a lower effective return in a taxable account, and on average, and when I say on average, I'm including all investors that are buying or selling a share (someone holding a share for years and years and years has no impact).

The pricing is based off of information. The information includes total post-tax return. Post-tax return is never the same as the pre-tax return for *all* investors on a given stock, unless it has a loss, and no dividend.

An individual's taxing situation is irrelevant, because we're looking at the taxing situation for all of the current investors in the market as a whole. The aggregate tax rate makes a difference.
IT-DevOps System Administrator

Post Reply