The Myth of Active Wealth Management: Why Beating the Index After Tax and Costs is Highly Unlikely

The Myth of Active Wealth Management: Why Beating the Index After Tax and Costs is Highly Unlikely

March 12, 2024

The allure of active wealth management has long been associated with the promise of outperforming market indexes. However, a closer examination reveals that this promise often falls short in the face of taxes and costs. In this article, we'll delve into the evidence to demonstrate why active wealth managers are highly unlikely to consistently beat the index over the long term. 

  1. Evidence from Academic Research:

Numerous academic studies have scrutinized the performance of active wealth managers against market indexes. One of the most cited pieces of research is the SPIVA (S&P Indices Versus Active) Scorecard, which tracks the performance of actively managed funds against their respective benchmark indexes. The SPIVA Scorecard consistently finds that the majority of actively managed funds underperform their benchmarks over various time horizons.

For instance, the SPIVA US Scorecard for year-end 2020 revealed that over a 15-year period, 87.56% of large-cap funds, 91.27% of mid-cap funds, and 94.55% of small-cap funds failed to outperform the S&P 500, the S&P MidCap 400, and the S&P SmallCap 600, respectively.

 

  1. Impact of Costs:

Active management typically incurs higher fees and trading costs compared to passive index investing. These costs erode the returns generated by active managers, making it even more challenging for them to outperform the index. Research by Vanguard, a prominent advocate for passive investing, suggests that expense ratios and trading costs significantly impact the performance of actively managed funds.

Vanguard's research indicates that lower-cost index funds tend to outperform their higher-cost actively managed counterparts over the long term. This is attributed to the compounding effect of costs, which eats into the returns generated by active managers.

 

  1. Tax Inefficiency:

Active trading within portfolios often leads to higher tax liabilities for investors. Unlike passive index funds, which typically have lower turnover and thus generate fewer taxable events, actively managed funds frequently buy and sell securities, triggering capital gains taxes. These tax implications further diminish the after-tax returns of active management strategies.

A study by Morningstar examined the tax efficiency of actively managed funds compared to index funds. The research found that index funds were generally more tax-efficient, resulting in higher after-tax returns for investors.

 

Final Commentary:

The evidence overwhelmingly suggests that active wealth managers face significant hurdles in consistently outperforming the index after accounting for taxes and costs. Despite the perception of skill and expertise associated with active management, the data indicates that the majority of active managers fail to beat their benchmarks over the long term.

Regarding the S&P 500 specifically, it's worth noting that this index is often considered the gold standard for measuring the performance of the U.S. stock market. Given its broad diversification and low costs through index funds or exchange-traded funds (ETFs), many investors opt for passive strategies tied to the S&P 500. The evidence presented underscores the rationale for passive investing, particularly through low-cost index funds, as a more reliable and cost-effective approach to long-term wealth accumulation.

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Caleo Capital USA (Caleo Capital NA LLC) are an integrated wealth advisory and asset management firm that serves high-net-worth South African families who have relocated or are planning relocation to the United States. Emigration and relocation is complex both administratively and emotionally, with so many aspects to consider. Financial planning for the average high-net-worth individual is no simple task, but tax, retirement, trusts and estate planning is even more complicated when your financial life spans international borders. Caleo Capital has established relationships with reputable partners who assist with a range of challenges facing newly immigrated clients.

Caleo Capital USA (“Caleo”) is a State Registered Investment Advisor.  Caleo and its affiliated persons only conduct business in those states in which it is lawfully registered or exempted from registration. This material is for discussion purposes only, and Caleo is not soliciting any action based upon it. This material does not constitute, and is not to be considered, an offer to sell or a solicitation of an offer to buy any product, security, advisory, risk management, or other service mentioned herein. It has no regard to the specific investment objectives, financial situations or particular needs of any specific recipient.  This material is not to be construed as investment advice nor is it intended, to constitute legal  or tax advice. Be sure to consult with  legal and or tax professional before implementing any strategy. For information regarding Caleo’s business operations, services, fees and registration status, please contact the firm or visit https://adviserinfo.sec.gov/ and search for Caleo  or for CRD #308542.