to the difference between the ending market value and ending cost basis. This would narrow the gap but the passive portfolio would still be ahead by 8.54 percent versus 8.04 percent. When we allow for 2 percent excess return, the active manager does return more than the passive strategy. In the case of bequest mode, it is 9.91 percent versus 9.08 percent. In the case of liquidation mode, the successful active manager produced 9.74 percent versus 8.54 percent. Table 32.4 demonstrates how the tax code punishes active management of equities. It is more difficult to add value on an after-tax basis than a pretax basis. In this example, about one-half of Mr. Street's excess return was lost because Mr. Street's portfolio turnover accelerated the payment of taxes. If an active manager can achieve additional appreciation through skillful portfolio management, the additional appreciation will generate additional taxes. We can calculate how much additional appreciation an active manager must generate in order to simply match the after-tax return of a passive strategy. The results are shown in Figure 32.1. The shape of the chart shows that any turnover greater than about 15 percent leads to meaningful tax impact. Much of the tax damage is done in the first 20 percent of turnover. The reason is that the impact of pretax compounding is related to holding period, which is the inverse of turnover. Five percent turnover implies a 20-year holding period. Thus, there is little difference between 30 percent turnover, which some consider to be low, and 75 percent turnover. Neither allows for much pretax compounding. These calculations all assume that turnover is tax-indifferent. Turnover is applied to the average level of appreciation in the portfolio. If turnover is applied in a tax-conscious manner, these relationships will change. For example, a policy of aggressively harvesting unrealized losses might lead to very high turnover in a weak market but would actually enhance the after-tax return. Adopting active strategies in a taxable portfolio is similar to paying a cover charge to enter a casino. The investor agrees to subject market returns to taxation in the hope that the active management will generate sufficient excess returns to cover the taxes. Even if the active strategies are successful, the benefit to the investor is only the net of the excess return and the taxes. A portfolio structure that shields much of the market's return from tax consequences of active management will allow the investor, rather than the IRS, to enjoy the benefit of any excess returns generated by active management. A "core and satellite" portfolio structure is the combination of a large diversified portfolio managed with a tax-sensitive strategy plus one or more concentrated TABLE 32.4 Annualized Pretax and After-Tax Returns, 25-Year Holding Periods After-Tax Return Pretax Bequest Liquidation Passive 10% 9.08% 8.54% Active, no excess return 10 8.18 8.04 Active, 2% excess return 12 9.91 9.74