Will AI-Driven Robo-Advisors Lose Their Edge Due to Taxes?

The taxation problem isn’t limited to AI-based robo-advisors. It applies to any actively managed investing strategy in general that holds positions for less than a year, incurring short-term capital gains tax.

Short-term capital gains are taxed at an investor’s income tax rate, while long-term gains are generally taxed at a lower rate, usually 15%, for most tax brackets. This tax environment poses significant challenges for active management, especially for those dealing with taxable accounts.

The Impact of Taxation on Active Management

Let’s consider an investor in the 28% tax bracket, corresponding to an annual income between $91,901 and $191,650 for the 2017 tax rates. When the long-term capital gains rate is 15%, an actively managed strategy that incurs short-term capital gains would require a 18% higher return to match the performance of a strategy that only incurs short-term capital gains.

For instance, a 10% annual return would only result in the same performance as an 11.8% annual return for the actively managed strategy. Whether this 18% increased performance is feasible depends greatly on the active strategy in question and its passive benchmark. Active bond funds tend to outperform active stock funds, making them more likely to see better returns.

Tax Advantaged Accounts vs. Taxable Accounts

From a tax standpoint, active management is largely irrelevant in tax-advantaged accounts like retirement accounts. These accounts are designed to shield the growth of investments from taxes, making it easier for investors to benefit from the performance of their portfolios. However, in taxable accounts, active management requires significantly higher performance to outperform passive strategies.

Capital Gains and Performance

The key takeaway is that active management must achieve substantially higher returns to outperform passive strategies, especially in taxable accounts. For instance, an active strategy might need to consistently outperform its benchmark by 18%, which is a significant hurdle to overcome consistently over time.

Portfolio-based investment strategies have a decent chance of beating passive strategies, primarily by avoiding major drawdowns that occur approximately every 4 to 5 years. This highlights the importance of a balanced and well-diversified portfolio to maintain performance and minimize the impact of market volatility.

Investors looking to adopt AI-driven robo-advisors should be aware of these tax implications and understand the trade-offs between active management and passive investing. By choosing the right strategy, they can optimize their portfolios to maximize returns and minimize tax burdens.

Conclusion: AI-driven robo-advisors cannot solely rely on active management to outperform passive strategies, particularly in taxable accounts. Understanding the tax implications and choosing a strategy that aligns with one's financial goals is crucial for long-term success.