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% alpha in Broad Market funds, but only 21% of the 1.80% alpha in Small-Cap funds for Australian superannuation (pension) fund investors. We also find that tax drag varies with investment style; market state being most detrimental during bull markets; and fund turnover – although the relation between turnover and after-tax alpha is non-monotonic. For high-income individual investors, tax drag is exacerbated to the extent that active management only generates meaningful alpha after-tax for Small-Cap funds of certain styles.
Our study highlights the importance of investigating performance and tax effects in a unified framework, and confirms the critical importance of considering tax when choosing between active and passive funds management.