Abstract
Recent advances in on–line portfolio trading have brought investors much closer to achieving the frictionless model often assumed in portfolio theory. Taxes, though, remain a significant barrier. The authors show that even a passive equity fund, such as the Vanguard 500, has a significant drag in the form of taxes, leaving an investor with only 54% of pre–tax value after 24 years. They find that passive portfolio investors can reduce taxes substantially by selling losing stocks and replacing them with characteristically matched stocks. The authors provide an analytic framework to quantify the effects of taxes on investment returns. The pre–tax returns are affected by two components: short versus long tax rates, and forgone earnings. They isolate the two effects to assess their extent. Using the effective tax rate as a measure of the tax drag, they find that the theoretical cost of forgone earnings is as high as 30% and that the theoretical cost of realizing short–term gains is as high as 31%. Different real–world equity strategies to reduce the investor9s effective tax rates are found to cut taxes by as much as 4.8%, significantly increasing the after–tax return.
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