Funds find pitfalls in reporting after-tax returns

Last-minute snags have tripped up mutual funds trying to report their performance based on after-tax returns.

Last week the Securities and Exchange Commission reluctantly granted the industry two more months – until Dec. 1 – to comply with the rules, which were adopted in January. The rules require the industry to use standardized figures for reporting after-tax performance. Funds must report after-tax performance for any fund advertised as being managed to limit taxes.

The agency granted the extension after Fidelity Investments, The Vanguard Group Inc., T. Rowe Price Group Inc. and Prudential Securities Inc. requested one in a last-minute letter dated Sept. 10.

The four large fund groups said they had discovered that there were differences in the way they were reporting their after-tax performance figures and the way third-party information providers were calculating the figures. One fund spokesman said the issue arose with the way Morningstar Inc. was calculating its figures.

third parties involved

The four companies operate fund supermarkets in which they sell funds managed by other companies. Morningstar in Chicago and other companies calculate the performance figures for those funds.

At the meeting the SEC held to announce the extension, two commissioners questioned why the fund industry waited until the last minute to ask for the delay.

“Is this an unduly cumbersome calculation?” asked Laura Unger. “What seems to be the problem that it would take them until 10 days before the rule was to be effective to figure this out?

“It’s almost the end of the period,” said Isaac Hunt. “We assumed they’d been working on it the whole time diligently. I just think that perhaps they should have been a little further along.”

The mutual fund industry had opposed the rule as written by the SEC. The industry objected to the way the agency insisted that after-tax returns be calculated.

For one thing, the rule requires that after-tax returns be based on the highest tax rates. That would likely cause confusion for the many investors who are not in the highest tax rates, the industry argued.

“The formula that was provided in the original release was really simply to follow the federal income tax law in all respects,” Susan Nash, associate director of the SEC’s division of investment management, said at the meeting.

“When they sat down to do it, they found that not everyone interpreted that the same way.”

Issues have arisen concerning the way capital gains and losses are figured. “Some folks,” Ms. Nash said, “interpreted what we said as requiring you to net first within the fund itself, so that you netted all gains and losses in the fund and then to assume that there were offsetting gains outside the funds. And other people did it the opposite way.”

Another problem is that the third-party information providers were calculating their figures based on assumptions and incomplete data, Ms. Nash said. “They knew the distributions that the funds have made,” she said of the third-party information providers.

“But they did not know the tax character of those distributions. They made simplified assumptions in order to get [the] data out into the marketplace. And [those] data [were] picked up and used by the fund supermarkets.”

The SEC rule requires more-precise computations, however. Third-party information providers are not ready to start calculating performance based on the new rules, Ms. Nash said.

Performance information posted by fund supermarkets is considered to be advertising, which would mean that the fund companies would have to stop displaying the information until the differences could be worked out.

Fund companies are to submit questions to the SEC within a week to clarify how the questions should be made, Ms. Nash said.

According to Don Phillips, a Morningstar managing director, “Our only policy is, whatever the SEC adopts or recommends is the way we will calculate after-tax returns. Morningstar is looking to the SEC for guidance here.”

He says the industry needs a uniform method that is easy for the public to understand. That will “help make investors more aware of the tax consequences of their investments,” he adds.