The impact of fees on long-term performance is a common marketing theme among ETF and other low-fee providers.
It’s a valid consideration, because fees reduce total returns. But there’s another drag on performance that can have more impact: taxes.
A perfect world
What would happen in a world without taxes or fees? Let’s look at two different portfolios where income’s automatically reinvested:
- Bonds: $100,000 growing at 6%
- Stocks: $100,000 growing at 9% (6% capital appreciation, 3% dividend yield)
Over 20 years, each would grow as follows:
- Bonds: $320,713
- Stocks: $560,441
Let’s now consider the impact of two different fee scenarios: high and low.
- Bond @ 1.80%: $227,695 ($93,018 total fee drag: 29%)
- Equity @ 2.50%: $352,364 ($208,077 total fee drag: 37%)
Low (cut both fees in half):
- Bond @ 0.90%: $270,429: ($50,284 total fee drag: 16%)
- Equity @ 1.25%: $444,985: ($135,626 total fee drag: 21%)
Because of compounding, halving fees doesn’t halve fee drag. Even small differences in a compound rate over a period as long as 20 years create disproportionate results.
Now let’s look at fee drag versus tax drag. There are three tax rates we need to consider: interest, dividends and capital gains.
Tax drag on fixed income
Interest earned on fixed income is taxable annually at the same rate as regular income. Consider two scenarios: high tax (50%) and low tax (25%). (These are close approximations of the upper and lower tax rates in several provinces.)
- 50% tax: $180,611 ($140,102 total tax drag: 44%)
- 25% tax: $241,171 ($111,193 total tax drag: 32%)
With interest income, the tax drag on performance is substantially worse than fee drag. In every possible combination, tax has a larger impact than fees:
- High Fee/High Tax: 29% versus 44%
- High Fee/Low Tax: 29% versus 32%
- Low Fee/High Tax: 16% versus 44%
- Low Fee/Low Tax: 16% versus 32%
Tax drag on equity
Consider these five variables when looking at the impact of tax on equity investing:
- capital appreciation rate;
- dividend yield;
- capital gains tax rate;
- dividend tax rate; and
- portfolio turnover ratio.
Return on equities consists of capital appreciation and dividends. We assume the after-tax amount is reinvested, as well as 6% capital appreciation and a 3% dividend yield.
Capital gains are easy to approximate. Given they are 50% taxable, we can assume half the rate used for fixed income. That means 25% for the high rate and 12.5% for the low.