Vanguard, Eaton Vance forge ahead, but others wait on Congress

In the growing debate over mutual fund tax efficiency, Vanguard Group may have rushed to the head of the parade, but others are waiting for Congress to call the tune on the best way to gauge after-tax returns.

Vanguard, based in Malvern, Pa., announced last month it would publish one-, five-, and 10-year pre-tax and after-tax performance results for 47 of its portfolios. Boston fund company Eaton Vance Corp. also said it would report after-tax returns in its tax-managed portfolios this year.

But other fund managers say they are taking a wait-and-see approach while Congress mulls legislation that would require companies to disclose a fund’s tax efficiency in prospectuses and annual reports.

Planners are eagerly awaiting action. “I’m a believer in the idea of more information,” says Richard Bregman, a principal of financial advisory MJB Asset Management in New York. “The financial planning community has been making lots of noise clamoring for more tax efficiency in mutual funds,” he says.

Clouding the issue, however, is a controversy over just how such after-tax returns should be measured. Calculating them has many variables that can produce a variety of outcomes, says Robert Hechler, president of Waddell & Reed Service Co., the mutual fund unit of Waddell & Reed Financial Inc. in Shawnee Mission, Kan.

“Do you disclose pre-liquidation or post-liquidation returns?” he asks. “And what tax rate do you use?”

Vanguard will make several assumptions, including assessing the highest individual income tax rate, 39.6%, for dividends and short-term capital gains and 20% for long-term capital gains distributions.

The Vanguard formula will also assume that investors have continued to hold their investments without liquidating shares.

Finally, Vanguard will ignore the impact of any applicable foreign, state or local taxes in its calculations.

Using pre-liquidation numbers will clearly show investors how a fund manager’s actions, such as portfolio turnover rates, affect a fund’s return, according to the company.

“The alternate method of calculating after-tax returns, assuming investors liquidate their holdings and realize additional taxes triggered by the redemption, tends to overstate the investor’s tax burden,” said Joel M. Dickson, a principal at Vanguard, in testimony before a House subcommittee.

But like gross performance results, after-tax returns won’t show a fund’s true tax efficiency, raising questions among some managers over the usefulness of the information.

An index fund may appear highly tax efficient now, but if the markets reverse and index funds have to sell securities because money is leaking out, there could be a marked change in those after-tax results, says Tom Bivin, executive vice president and national sales manager at Ivy MacKenzie Funds in Boca Raton, Fla.

Finally, after-tax performance figures aren’t a one-size-fits-all solution. After-tax disclosure would be identical for all shareholders in a fund, even though investors have vastly different financial profiles.

monumental task

Ed Rosenbaum, director of research at Lipper Inc., says it’s unlikely that funds will personalize every tax efficiency calculation.

“Mutual funds would have to assume the burden of ultimate tax planning for each investor,” he says.

If Congress eventually approves the legislation before the House or a substantially similar bill, the Securities and Exchange Commission would have to formalize requirements for mutual funds to disclose after-tax performance returns.