If you’re an American expatriate, and you’ve been living overseas for some time, it’s likely that the vast majority of your investments will be in taxable accounts. 

As a non resident, your ability to invest in a IRA (tax deferred account) is limited to just $5000 a year if you’re under age 50, and $6000 a year, if you’re over age 50.  …more info 

Financial advisors dealing with expatriate Americans will understand these limits.  But there’s something that many advisors don’t know—and their lack of knowledge here could cost you tens of thousands or hundreds of thousands of dollars.

The Paradox Your Advisor Doesn’t Know

Let’s assume that you invested $10,000 in five stocks, and you owned those stocks for ten years, generating an average return of 8 percent per year in a taxable account.

Now assume that—in a taxable account– you’ve invested another $10,000 in an actively managed mutual fund that averages 9 percent a year over the same time period.  Which scenario would give you the highest return?

The answer seems painfully obvious, doesn’t it?

But it isn’t.

You would make more money investing in five stocks, generating 8 percent per year than you would in an actively managed mutual fund generating 9 percent a year.

How Can An Eight Percent Return Beat A Nine Percent Return?

When money is invested in a taxable account, it can compound (free of capital gains taxes) until the asset is sold.  So if you owned 5 stocks, averaging 8 percent a year, you wouldn’t pay a penny in capital gains taxes until you sold those stocks.

But actively managed mutual fund investors don’t benefit from the same perk.  For example, actively managed funds hold stocks that are traded by fund managers.  If a fund manager sells a stock at a profit, the fund’s investors get handed the tax bill.  Rather than the mutual fund compounding capital gains free, it creates a tax bill for its investors as it appreciates.  If the fund appreciated every year, the investors that own that fund would pay capital gains taxes every year. 

How Do You Get Around This?

I’m not going to suggest that American expatriates fill their taxable investment portfolios with individual stocks.  However, if their investment portfolios are comprised of index funds, the money can compound, virtually capital gains free—even in a taxable account.

Let’s use Vanguard’s total stock market index as an example.  It had an annual holdings turnover of just 5 percent last year.  … more info

This means that the fund sold only 5 percent of its stocks last year, and it held on to 95 percent of them, year over year, ensuring extraordinary tax efficiency.

The average actively managed stock fund in the U.S. has a turnover that’s fifteen times higher than that, creating a significant (after tax) drag on returns as the mutual fund managers bought and sold stocks within their funds.

The Tale of Two Funds

If you had invested in The American Funds Investment Company of America mutual fund, your pre-tax returns from 1979 to 2003 would have been an impressive 13.7 percent per year.

If you had invested in Vanguard’s S&P 500 index fund, from 1979 to 2003, your pre-tax return would have been 13.8 percent per year.

There’s little difference between the two performances, right?

Wrong.

In John Bogle’s excellent book, Don’t Count On It!  Bogle lays a comparison between the two funds, assuming that they were each invested in a taxable account.

Fund	Amount invested in 1979	Amount invested after sales fees	Average percentage gain	Pre-Tax Value, 2003	Estimated annual taxable liability	Est. Post tax annual return	Est. Investor’s value in 2003
Vanguard S&P 500 Index (VFINX)	$10,000	$10,000 (no sales fees for Vanguard)	13.8%	$253,254	-0.9%	12.9%	$207,657
American Funds (ICA)	$10,000	$9,425 (after 5.75% sales fee)	13.7%	$233,583	-2.5%	11.2%	$133,937

Source: John Bogle, Don’t Count On It! Pg. 384

Before taxes, from 1979 to 2003, the Vanguard S&P 500 index and the American Funds Investment Company of America earned virtually identical returns: 13.8 percent and 13.7 percent respectively.

But after tax, there was a huge difference in performance.

Actively managed mutual funds don’t make much sense in taxable accounts.

Jason Zweig, when writing for Money, interviewed investment manager, Ted Aronson, who suggested that, after taxes, active management can’t win. Aronson manages more than $2 billion, and despite being an active money manager himself, all of his family’s taxable money is in index funds. 

Expatriate Americans, when investing money, will direct the bulk of their savings to taxable accounts.  And sadly, because of their advisors’ cravings for commissions, that money will likely find its way into actively managed funds.

Before taxes, roughly 85 percent of actively managed mutual funds will lose to stock market indexes.  And we’ll never know which 15 percent of actively managed funds will beat the total market index, over the next five years, ten years or twenty years.  Gambling your retirement money on such low odds is foolish.

But even if you get lucky, and find a fund that ends up beating the index, will you really be coming out ahead, in a taxable account?

It’s highly unlikely.

Your investment advisor probably doesn’t know this.

And his or her ignorance–or conflict of interest–could cost you tens of thousands (or hundreds of thousands) of dollars over a working career overseas.

In my next post, I’ll show you the pride and joy of the expatriate American Funds salespeople.  It’s a fund that has a long-standing historical record of thrashing the indexes.  A fund’s historical performance is a poor gauge  of how it will do in the future, but that’s not the point I’m going to make. …more info

I’m going to prove that it hasn’t had such a stellar after-tax historical performance after all.  Stay tuned.