When the returns of various funds, fund managers, or ETFs are bandied about, the discussion is usually centered around pretax rates of return. While this measure makes sense for retirement accounts, pensions, charities and endowments, regular investors have to pay significant taxes on their returns and therefore consideration to tax minimisation must be given.
For these investors, pretax rates of return across funds are not comparable, since investment income can come in many forms including interest, dividends
, and capital gain
s. Complicating matters for investors is the fact that tax rates can vary (sometimes dramaticall
y) across all of these categories, making investment comparisons across categories non-trivial.
Furthermore, tax regimes vary by jurisdiction: while Americans may be subject to low
er tax rates on capital gains versus interest income, Colombians face just the opposite situation, with heavy taxes on capital gains and favourable rates on interest income. Knowing the tax regime of your country will help you compare investment possibilities on an after-tax rather than a pretax basis.
For almost all jurisdictions, however, capital gain taxes can be deferred as long as the investment is not sold. The longer this deferral is prolonged (i.e. the longer the investor holds the security), the lower the effective tax rate on the gains becomes. This would seem to suggest that a buy and hold strategy is the most tax efficient, which just happens to be the preferred method of choice for value investors.
However, tax efficiency is no substitute for the value of superior returns: even a highly taxed investment will outperform a poor investment, even if it should be tax-exempt. The point is not to base investment decisions on their tax treatment, but rather to compare investments on an apples-to-apples after-tax basis, and so the reported pretax returns that are the industry norm just don’t do the trick.