The Wealth Multiplier: Tax Efficiency & Compounding

We often emphasize to our clients the pivotal role of tax efficiency in magnifying their wealth over time. Though the topic might seem tedious, our fascination with it is well-grounded.  We often say: “we prioritize after-tax wealth creation, above headline returns.”

Imagine you're at a rewarding juncture in your career, with a $3 million nest egg you're eager to grow. As you delve into the investing realm, three captivating strategies catch your eye:

1.     S&P 500 (Passive Strategy): By channeling your funds into a low-cost ETF tracking the S&P 500, you're riding on a 25-year legacy of 8.3% annual returns[1]. Past performance is no guarantee of future performance, but if the next 25 years are similar, your $3M could turn into a staggering ~$22 million, a 7x upswing!

2.     One-Year Wonder (Active Fund): There's a firm, "1-Year Hold Capital," outpacing the S&P 500 by 1.7% annually. Their 10% annualized return over a quarter-century, translating to a 10.8x money multiplier, intrigues you.

3.     The Monthly Maverick (Active Fund): The “1-Month Hold Capital” is a highly-skilled, highly active trader, boasting a 12% annualized return over the past 25 years, elevating investor wealth by 17x!

However, there's a tax snag with the latter two active strategies.

• The One-Year Wonder rebalances its portfolio annually, and pays a long-term capital gains tax annually, causing a 3% annual tax drag (assuming a 30% long-term capital gains tax rate from combined Federal, State and Local taxes).

• The Monthly Maverick, with its frequent trading, faces short-term capital gains tax, incurring a 6% yearly tax dent (assuming a 50% short-term capital gains tax rate from combined Federal, State and Local taxes).

For the sake of simplicity, you assume the next 25 years are going to be very similar to the last.  Crunching these numbers unveils a surprising truth, despite the pre-tax allure of active strategies, post-tax returns[2] level the playing field:

Source: Ahara Advisors

The passive S&P 500 strategy beats the active strategies above after taxes.  This is not an original conclusion.  Warren Buffett has written at great length about this topic.

This simplified illustration, albeit laden with assumptions, greatly molds our investment perspective. In the equity arena, our eyes are set on outshining the after-tax S&P 500. The potential rewards are enormous.

Consider a scenario where a savvy money manager combines the 10% returns of the One-Year Wonder with the tax efficiency of the S&P 500 - call it “Tax Efficient Alpha”:

This strategy outshines the others and puts an additional $7.3M of after-tax gains into the investor's pocket.

Source: Ahara Advisors

There are a few ways we can help make an active strategy more tax-efficient:

• Long holding periods

• Selling securities with low expected returns at a realized loss

• Gifting highly appreciated securities to a charitable organization (or Foundation, Donor Advised Fund)

 In addition, it’s sometimes possible to put high-return active strategies into tax-advantaged vehicles like IRAs. 

 It's these possibilities that fuel our excitement. By nudging performance upward while keeping tax at bay, at Ahara Advisors we're on a quest to catapult our clients into a realm of remarkable wealth and impact.

P.S. This post was partly inspired by the 1989 Berkshire Hathaway Annual Letter. 

P.P.S. - ChatGPT also helped to edit and refine this article.

[1] S&P 500 annualized return of 8.3% from August 1998 – August 2023. This is a historical datapoint that we assume will continue into the future for this analysis, however, we want to note that past performance is no guarantee of future performance.

[2] For the S&P 500 we assume reinvestment of dividends, with no tax drag on dividends for the S&P 500.  After-tax value is calculated by applying a 30% Long Term Capital Gains tax rate to the appreciation of the position.