No matter what, the long-term investor comes out ahead of the short-term trader

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Last time, we looked at why traders are at an almost insurmountable disadvantage against investors due to short-term capital gains taxes. Many of you wrote in to note several factors that would have allowed the active trader to narrow the gap against the long-term investor. A few of you asked how likely it was that a trader would outperform by that margin year after year. This week, I want to review those issues readers raised, looking to see how they affected our competition between the long-term indexer and the short-term trader.

Spoiler alert: The issues to which I gave short shrift did improve the performance of the trader, but not nearly enough to narrow the gap between the two. Let’s look at the details.

Ritholtz is chief investment officer of Ritholtz Wealth Management. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture. View Archive

There are three factors I oversimplified or overlooked: The first is the tax loss carry forward. This was the biggest issue raised by readers and the one that had the single biggest impact on the net performance of the trader’s account.

As readers noted, the IRS allows losses from past years to be carried forward, reducing the tax bite in outlying years following a big down year such as 2008 or ’09. This will narrow the gap between our two competitors. For the two to see similar performance net of taxes, the trader need only outperform the benchmark index by about 30 percent instead of the 40 percent we discussed. A challenging bogey to be sure, but less so than I originally stated.

Second, several people raised the issue of dividends working for the investor but not for the trader. I elected to ignore them for traders in my comparison and ended up understating the trader’s performance ever so slightly. An account that is trading equities actively, with relatively short holding periods, may or may not be a holder of record when a dividend is issued in any given quarter. And when a stock goes ex-dividend, its share price typically drops by the amount of the dividend, making it a wash to shorter-term traders. Some readers who trade actively noted that they had healthy dividend incomes each year and had the tax filings to prove it. However, the amounts involved relative to the investor were minor.

Consider that an investor who held on to the Standard & Poor’s 500-stock index for the year of 2013 captured a dividend yield of a little over 2 percent. I assumed traders missed at least half of that, as they were buying and selling stocks. They then paid taxes on what they did collect. We are left with a likely gain of plus or minus 1 percent, and I suspect for many active traders, it’s closer to zero than 1 percent. I discounted the dividend to traders entirely, as it’s not especially significant to the total performance. I am going to stay with that call.

The third factor several of you pointed out, which is significant, was that the long-term investor still owed taxes on their gains. Assuming the portfolio was not in an IRA or 401(k) or other tax-advantaged structure, long-term capital gains are owed. Our passive index investor is likely to owe a 20 percent capital gains tax when cashing out. Keep in mind, however, that this investor typically draws down 4.5 percent per year in retirement. Their tax bite is going to be at its lowest level in their lifetime during retirement. Given modern life spans, they can also expect to benefit from continuing appreciation of their passive portfolios during their 20-plus years of retirement.

These taxes will narrow that gap, but it is offset by potential gains over the retirement period. The extent of the offset depends on how much the market gains over that 20-year period. Active traders do not garner that benefit (unless they roll their trading accounts over into a broad index). Note that I assume none of you plan to spend your golden years watching the market tick by tick and jumping in and out of stocks.

In our theoretical competition, if the issues raised by readers are resolved in the trader’s favor, the gap between the two is narrowed. Losses carried forward reduce the disadvantage to the trader, dividends help ever so slightly and taxes owed by the investor reduce his net gains. Let’s assume that all ties go to the runner: If we were to be aggressive in our assumptions favoring the trader, all the benefits of those issues raised by readers to the active portfolio reduce the outperformance by the indexer. But it is still substantial, as the active trader “only” has to outperform the S&P 500 by 25 percent instead of 40 percent.

Those were the issues raised by traders who challenged my underlying premise. Readers who were sympathetic to my argument raised different but just as important questions. Three issues from the investor side were: 1. How likely was it that any trader was going to beat the market in any given year? 2. By how much was that trader likely to beat the market? 3. What are the odds the trader would beat the market 20-plus years in a row?

These questions get to the heart of the active vs. passive debate. The data is terribly unfavorable to the active trader by an immense margin. Indeed, the math of active management is daunting.

Let’s use mutual fund performance as our stand-in for active traders. Data from Morningstar and Vanguard shows that in any given year, 20 to 30 percent of active managers can outperform their benchmarks. Note that this is usually by a few percent, and not the 25 percent we have discussed.

But that’s for only one year. Where things get interesting is what happens when we look at consecutive years. For any manager who outperforms in a given year, only 1 in 10 will continue to outperform in two of the next three years. In other words, 10 percent of our original outperformers — about 3 percent total — can keep their streak alive for three consecutive years. Over five years, only 1 in 33 of our original alpha generators keeps the winning streak going. Once we figure in their costs and fees, it works out to be less than 1 percent — 1 in 100 — who manage a net outperformance of a few basis points a year.

Perhaps the best-known winning streak of all time has been that by Legg Mason’s Bill Miller. Over 15 years (1991-2005) his Capital Management Value Trust (LMVTX) outperformed the S&P 500. Note that this period included two Middle East wars, the dot-com crash and the housing boom. Miller, a deep-value manager, saw his streak end when the housing boom busted and the credit crisis crushed the financial sector (LMVTX had concentrated exposure to that sector). The fund went from the top 1 percent of all mutual funds to the bottom 1 percent over the ensuing years.

Hence, our thought experiment requires us to begin with what has proved to be an impossibility: beating the market by a substantial percentage for an unprecedented number of years.

I may have somewhat overstated some of the tax disadvantages of the active trader vs. the passive indexer. But the bottom line remains the same: Short-term taxes that are paid — and therefore not compounded over the decades — take a huge bite out of a portfolio. That assumes you are a terrific trader. But the odds are that you are not. Forget alpha, or market beating returns. Most people don’t even achieve beta, which is market matching returns. In the real world, the win goes to the passive indexer.

Ritholtz is chief investment officer of Ritholtz Wealth Management. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture. Twitter: @Ritholtz.


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