International investing doesn’t have to be a tax burden

Businessman with boulder Many investors don’t pay enough attention to taxes generated from investing. For example, they will invest money from a taxable account into a traditional active management mutual fund, with higher turnover, thinking that the excess returns they receive will more than offset taxes generated. This thinking couldn’t be more wrong. Further, investors that do explicitly construct tax-sensitive portfolios tend to take a concentrated approach, focusing in the U.S. and avoiding international investments. Let’s examine this thinking. Consider that over the 12 months ending March 2015, the average international equity mutual fund return was reduced by taxes by 2.45% (the tax drag), materially reducing the pre-tax return. Going back 10 years, the average international fund lost an average of 1.14% to taxes.1 The large losses and loss carry-forwards generated from the financial crisis makes the longer history look better than we should expect going forward. However, let’s consider a hypothetical example using the smaller, longer-term 10 year number. $100,000 projected forward 20 years with a 7% growth rate grows to $387,000. Using the 10 year tax drag number of 1.14%, this would only grow to $312,000. This represents a 20% reduction in the amount of wealth accumulated. But as I mentioned, expect forward-looking tax drags to be higher, and the detrimental effect of taxes on compounding wealth to be larger. Indeed, investing internationally can be costly after taxes. International equities have foreign taxes, higher dividends (which cause taxes) and higher tax rates than domestic equity investments due to the treatment of dividends. For those approaches that are oblivious to taxes, it turns out this same terrible after-tax performance exists in U.S. equity universes too. For example, the difference between the pre-tax return and after-tax return of the average small cap fund is even worse than international. Over the last 12 months ending March 2015, the average small cap fund had a tax drag of 3.86%. Going back 10 years, which includes the financial crisis, reduces the number to 1.56%.2 As you can see, when a tax-aware approach is not considered, taxes are a concern when investing domestically, too. Investors don’t need to subject themselves to poor performance due to tax inefficient investing. Investing in international equities can be tax inefficient partly for the reasons discussed above, but mostly for the same reason U.S. equities are tax inefficient—many money managers are focused on generating pre-tax returns and make decisions that destroy wealth after taxes are considered. Regarding the efficiency of international investing after tax, consider that only about 5% of the dividends you receive from developed international equities will be treated as non-qualified income; this number is around 20% in emerging markets.3 Neither of these is that material, especially considering that these more toxic dividends may likely be used to pay investment expenses prior to taxes being paid (most of the non-qualified income will never hit the investor). And you will receive a tax credit for foreign taxes paid that can be used to offset other taxes you pay. So what on the surface seems like a big tax problem is actually quite small. But those are not the only challenges, the higher dividend yields internationally are somewhat of a problem, but one that can be corrected by a smart money manager. The real reason international equities are typically tax inefficient is due to poor tax management by money managers. There can be a real benefit to global diversification that should not be discarded due to the appearance of higher taxes. You can help your clients obtain the value of global diversification in their taxable accounts by investing in funds that explicitly manage taxes. A fund that takes a long-term perspective, avoids costly turnover such as those generated from short-term gains, tilts away from high dividend yielding securities and systematically harvests losses that can be used to offset gains may save your clients a lot of money in taxes and allow them to compound more wealth.

The bottom line

1) Make taxes a central objective of the management strategy for taxable accounts. 2) Investing internationally may help clients benefit from diversification--a tax-managed strategy may also be beneficial. Your clients will thank you.
1 Source: Morningstar, International Equity category, all share classes. Tax drag is the difference between the total return (pre-tax return) and the post-tax pre-liquidation return. 2 Source: Morningstar, US Small Blend category, all share classes. Tax drag is the difference between the total return (pre-tax return) and the post-tax pre-liquidation return. 3 Source: Russell Investments, research based on IRS specified countries without U.S. tax treaties and country weights. Please remember that all investments carry some level of risk, including the potential loss of Principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns. Global, International and Emerging markets return may be significantly affected by political or economic conditions and regulatory requirements in a particular country. Investments in non-U.S. markets can involve risks of currency fluctuation, political and economic instability, different accounting standards and foreign taxation. Such securities may be less liquid and more volatile. Investments in emerging or developing markets involve exposure to economic structures that are generally less diverse and mature, and political systems with less stability than in more developed countries.