Capital Gains Taxes: Another Reason Vanguard Detroys Mutual Funds

One of the best books I’ve read on passive or index investing is The Elements of Investing by Burton Malkiel and Charles Ellis. The book is full of proof that buying mutual funds is a losers game for us, the investors.

One point they discuss that is not widely considered is the significant capital gains taxes that mutual fund investors are responsible for. Mutual fund managers are very active in buying and selling stocks in their fruitless attempt to beat the market.

Every time they sell a stock for a gain, you the investor have to pay tax on that gain. Many mutual funds turn over their stocks 100% in any year; that means the stocks they hold at the beginning of the year are completing different from the ones they hold at the end of the year.

Compare this to index funds which own the whole market. Unless a company declares bankruptcy or is bought by another company, the turnover is very low. This tax efficiency becomes a major advantage of whole market index funds. Mutual funds can create large tax liabilities if you hold them outside your tax-advantaged retirement plans (that’s a fancy word for outside your RRSP or TFSA accounts).

To overcome the drag of high fees and taxes, a mutual fund would have to outperform the market by 4.3 percentage points per year just to break even with whole market index funds.

The odds that you can find an actively managed mutual fund that will perform that much better than an index fund are virtually zero.