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By Michael Ide

Thornburg Investment Management says that most investors don’t appreciate the importance of expenses and taxes on long-term portfolio performance.

It’s easy to get caught up in day-to-day market movements, but as most successful investors tell us, long-term success boils down to avoiding big losses and unnecessary costs. Between taxes, fees, and inflation, impressive nominal returns can be reduced to almost nothing pretty quickly. To help investors get a sense for just how important it is to take those costs into account when building a portfolio, Thornburg Investment Management (H/T Cullen Roche of PragCap) has calculated the "real real return" for every major asset class, and the results are much lower than you might expect.

“Nominal returns are a misleading driver of an investor’s investment and asset-allocation planning. That’s because they are significantly eroded by taxes, expenses and inflation,” says the Thornburg report. “Examining the real real returns of individual asset classes over longer periods can help investors build more successful portfolios.”

Taxes and fees, cutting returns down to size

If you invested $100 in the S&P 500 (NYSEARCA:SPY) back in 1983 and held it there for 30 years, you would end up with $2,346, a nominal 11.09% annualized return, but for someone in the top tax bracket (Thornburg assumes that its clients are paying the highest available tax rates throughout its study), a combination of expenses, taxes, and inflation would cut that down to $570, or 5.97% annualized "real real" return.

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Thornburg isn’t picking on the S&P 500 -- a similar effect exists no matter where you put your money -- and large-cap stocks actually end up better than other asset classes. But it’s the difference between asset classes and how they are affected by fees and taxes that Thornburg really wants to address (the impact of inflation is the same across the board, of course).

Holding stocks in tax-deferred accounts, for example, would have resulted in a lower real real return than if you had held them in a taxable account, while the opposite is generally true for fixed income, as many of our readers probably know.

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Tax efficiency can make a huge difference to real returns

But when you start breaking down the real real returns of different asset classes, you find that some assets are more attractive than their nominal returns suggest. Municipal bonds, for example, have a lower nominal return than long-term government bonds or investment grade corporate bonds, but when you take the tax savings into account (again, assuming the portfolio is for someone in the top tax bracket), munis get pushed to the top. Commodities and T-bills, on the other hand, don’t even keep up with inflation once you take other costs into account.

Those returns are calculated based on performance and tax laws over the last thirty years (both of which can change dramatically), and looking back over different timeframes gives slightly different results, but it gives you an idea of how important costs are when considering investments.

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Disclosure: None

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Source: Thornburg On Understanding Your Real Real Returns