Taxes have a huge impact on investment returns. The Bogleheads Guide to Investing cites a study by Charles Schwab that found that for the 30-year period from 1963 to 1992, $1 invested in U.S. equities would have grown to $21.89 in a tax-deferred account but only to $9.87 in a taxable account for a taxpayer in a high tax bracket.
Index funds are tax efficient in two ways. First, index funds can be bought and held “forever” with high confidence that they will outperform the vast majority of investors, who are presumably chasing performance and buying “hot” funds and selling them when they almost invariably turn cold. Second, the turnover of the index funds is extremely low because changes are made only when stocks are added to the index or when stocks leave the index or when companies merge, are taken over or go bankrupt. Hence, realized capital gains that are distributed to the investor and taxed in her hands are very low.
Consider the Vanguard Total Stock Market ETF (VTI) whose portfolio turnover for the past five years were 4%, 4%, 12% (due to a change in the fund’s target index), 4% and 2% respectively. In contrast, it is impossible to tell what the turnovers for the larger U.S. equity mutual funds in Canada because such information is not available in the prospectus. Leith Wheeler, to their credit, publish such information for their U.S. Equity Fund and reported a turnover of 17% (to June 2007) and 25% in 2006. The Vanguard Europe Pacific Fund (VEA) also has very low turnover: 6%, 4%, 4%, 5% and 9% in the past five years. The low turnovers will result in lower realized capital gains distributed to investors over time and result in higher after-tax returns when compared to actively managed funds.