Monday Morning: In terms of tax efficiency, funds are low

The topic of the tax efficiency of mutual funds has been a common one at conferences for financial advisers for several years, though it waxes and wanes. And it seems to bubble up at this time each year, soon after the mutual funds have declared their capital gains distributions and just before investors begin to think about tax season.

Investors would be happiest if they could avoid taxes altogether on equity mutual fund investments outside of tax-deferred retirement accounts, but that’s not possible.

So just how big is that tax burden? How good are mutual funds in managing the tax effect?

A new study by Robert D. Arnott, Andrew L. Berkin and Jia Ye of First Quadrant LP in Pasadena, Calif., shows taxes can have a significant impact on mutual fund returns.

The authors compared the pre- and after-tax returns of the Vanguard Index 500 Fund with the returns of actively managed equity funds over 10, 15 and 20 years ended December 1998. They found that if an investor had put $1,000 into the Vanguard Index fund 20 years ago, it would have grown to $24,000 before taxes.

After adjustments for capital gains and dividend taxes, the value would have dropped to $16,200, and if the investor sold at the end of the 20-year period, the value would have dropped to $13,800.

If an investor placed the $1,000 in the average actively managed fund instead of the index fund, it would have grown to $19,600 before tax, $11,300 after capital gains and dividend taxes and $10,600 upon liquidation. They found the results similar for the 10-year and 15-year holding periods.

So the study shows that mutual funds, on average, are not very good at tax-efficient investing.

The authors comment that “the way taxable assets are managed poses a very serious problem for the taxable investor. Most mutual funds do a disservice to their clients by ignoring or dismissing the taxes triggered by their trades.”

The first thing that becomes apparent from the above figures is that the index fund beat the average actively managed fund by a substantial margin on a pretax basis over the 20-year period – $4,400.

The reasons are the lower transactions costs of the index fund, because it trades relatively infrequently, and also the small-cap bias of most active managers during the period, a time when the market favored large-cap stocks.

The second is just how large the impact of taxes was, even for the supposedly tax-efficient index fund. The capital gains and dividend taxes cut the index fund return by $7,800. For the average actively managed fund, the taxes reduced the return by $8,300.

lower return, higher tax

The third conclusion is that the average actively managed equity mutual fund portfolio not only underperformed the index fund for the 20-year period but also paid much higher capital gains taxes, presumably because of higher turnover in the active funds.

Clearly, there is a role here for financial advisers. Not only must they try to identify the best-performing mutual funds that match their clients’ needs, but they must also try to identify the most tax-efficient funds within the chosen universe.That will take some digging.

But no one said being a financial adviser is easy.

Mike Clowes is the editorial director of InvestmentNews.

Related Topics: Just Thinking