Turnover Rates and After Tax Returns

Abstract

Many active managers have very high annual turnover rates. While the tax cost from turnover can be viewed as a transaction cost which should be compared with the value it adds, that approach leaves open the question of whether the expected after tax return, given the turnover rate, is equal to or greater than the return which could have been obtained in other, more passively managed benchmark vehicles. To develop a consistent approach to answering that question, this article applies a constant decay model, which allows the integration of the gross turnover rate, the proportion of gains which should be long and short term, the expected deferral period before those long and short term gains are subject to taxation, and the tax rates at which those gains will be taxed. With that model, the effect of different fee structures can be analyzed, including a typical asset based mutual fund, as well as a performance based hedge fund structure.