David Eisenhauer is the founder and chief wealth strategist at Greykasell Wealth Strategies.
In a recent piece, I explained why many investors believe their portfolios are underperforming, even though the experience often looks worse than the numbers suggest. This time, I want to examine the opposite problem – investors overestimating their returns because taxes can make performance look better on paper than it feels in real life.
Over time, two portfolios can post nearly identical headline gains and yet deliver very different real outcomes after taxes. When that happens, the difference has little to do with market timing or manager skill. It comes down to the structure of the investment itself.
This is easiest to see in traditional mutual funds, which are required to distribute most realized gains and income each year. Even if you never sell a single share, taxable income can still land in your account simply because the fund sells positions internally.
In a taxable account, that often means you owe taxes even when the portfolio itself barely grows.
Here is what that looks like in practice over a longer period. The chart below shows Brown Advisory Growth Equity Fund’s (BIAGX) total return over roughly the last three years: about 57%. The issue is that the net asset value (NAV) fell about 58%, a disparity of roughly 115 percentage points.
Source: YCharts
Is this an outsized example? Yes. But this is a basic feature of mutual funds: gains realized anywhere inside the fund are shared among everyone who owns it, regardless of when they bought or their personal tax situation. And it’s why heavy distributions and poor tax management can devastate returns.
The migration to ETFs
ETFs operate differently. Through in-kind redemptions and mechanics unique to their structure, ETF managers can remove appreciated securities without forcing taxable gains on remaining shareholders. For investors, that means taxes can often be deferred instead of distributed.
While the impact may seem minor in any single year, over time it is anything but.
Indeed, two portfolios can hold almost identical investments and generate nearly identical pretax returns. But because one (a mutual fund) distributes taxable income year after year while the other (an ETF) remains largely tax quiet, their outcomes begin to diverge. The portfolio that defers taxes keeps more money invested, which allows it to compound from a larger base.
This helps explain the ongoing migration away from mutual funds in recent years. Investors are not chasing better market returns. They are simply trying to stop losing ground to taxes they never consciously chose to pay.
The push for greater control does not stop with ETFs
That same logic is now driving renewed interest in direct indexing and individualized portfolios built from individual stocks rather than pooled funds. Instead of owning a single fund, investors own the underlying companies themselves. Market exposure can remain largely the same, but flexibility changes dramatically.
Owning individual securities allows advisors to harvest tax losses selectively, avoid realizing gains unnecessarily, donate appreciated shares to charity without incurring taxes, and rebalance without dumping low-cost-basis positions. These tools restore the timing control that pooled structures remove. Making this easier is the fact that individual trades on most investment platforms are now free.
When done carefully, direct indexing can enhance after-tax results while closely tracking the broader market. The real point is not beating the market. It is getting back the control pooled funds take away, including when gains are realized, how taxes are managed and how charitable giving is timed.
What Really Determines Results
If it’s not clear by now, it should be: wealth is built after taxes, not before them. One portfolio may quietly leak capital through unavoidable taxable distributions while another defers taxes and preserves compounding. They can look identical on paper yet end in very different places.
The most overlooked investment cost is not a management fee or an expense ratio. It is the slow erosion of compounding caused by tax inefficiency.
You usually don’t notice it in any single year. But you will feel it at the end.
