Our clients will be receiving annual reports, prospectuses, and statements of additional information from their fund families over the next several weeks. Despite most people's general disinterest in these documents, the reports can provide hidden gems of information that can help us to add incremental returns to clients' investments. In particular, I like to look for information on after-tax returns, tax-loss carryforwards, and tax overhang. For taxable investors, these tidbits can be very instructive about their fund's relative tax efficiency.
Why should we care about taxes? In a 2012 study, Lipper showed that for the 10-year period ended Dec. 31, 2011, taxable equity fund investors surrendered an average of at least 75 basis points of their returns each year to Uncle Sam for doing nothing more than buying and holding their funds. Taxable fixed-income fund investors handed in some 186 basis points of their returns.
I can already hear the naysayers grumbling that we shouldn't let the tax tail wag the dog, and I couldn't agree more. But since more than half of the $13 trillion in U.S. open-end mutual funds is in taxable accounts and many clients are beginning to draw down their qualified plans, we need to educate them on the impact tax drag can have on portfolio returns and help them find ways to mitigate the influence of taxes. It is just one more piece of the puzzle to help clients make informed decisions about funds. I personally have seen significant differences in the rankings of funds based on their total return versus their pre-liquidation after-tax return. So, for taxable accounts I suggest augmenting total return with some measure of after-tax performance (ATP).
Under the Revenue Act of 1936 and the subsequent clarifications in Subchapter M of the Internal Revenue Code of 1986, regulated investment companies (mutual funds) are required to pass through virtually all of their realized income distributions and capital gains to their shareholders each year in order to maintain their regulated investment company status and avoid taxation. Shareholders may be responsible for taxes incurred by the funds, even though they did not sell any shares.
At present, a shareholder in a taxable account is required to pay taxes on all net gains and income dividends realized and distributed by the fund in the calendar year, regardless of the shareholder's actual cash receipt of the distribution (many investors have their distributions automatically reinvested). Keep in mind that for mutual fund investors, unless they actually sell shares, the time they hold a mutual fund is irrelevant to the type of gain that is passed through by the fund company. A shareholder could purchase the fund one day before the fund goes ex-dividend and have both long- and short-term taxable distributions and the consequent tax liability just one day later.
Because tax drag is often the largest drag on fund performancesometimes double or triple the drag of fund expenses and loadsCongress passed the Mutual Fund Tax Awareness Act of 2000, requiring improved disclosure of after-tax performance for mutual funds. It required mutual funds to disclose standardized after-tax returns for one-, five- and 10-year periods in the risk/return summary of the prospectus and to present after-tax returns on pre-liquidation and post-liquidation bases.
This is where the blank stares often start. So, let's review the different types of returns we can use to evaluate performance drag and to create meaningful comparisons between funds. One way to see the impact taxes have on a portfolio is to compare after-tax performance to the load-adjusted or SEC standardized return for the same period; the difference between the two is the tax consequence. But, let's start even further back, so we can see the drags on performance in a step-wise fashion (see the chart on page 39 for a comparison of how taxes lower five performance measures).
At the top of the spectrum, we have gross performance or expense-adjusted performance. This performance figure represents the hypothetical return of the fund, assuming operating expenses have not been deducted over the performance period. The difference between gross performance and total return is the fees and expenses that are assessed to manage the fund and that generally affect only the daily NAV. This measurement does not include distribution fees like loads or contingent deferred sales charges, but it does factor in the reinvested dividends and capital gains that accrue over the measurement period.
The next step down and the result of expense drag is total return. This figure is the return cited most often in financial publications. For performance periods of one year or longer, it is generally the annualized percentage change of the NAV (return less expenses) and also factors in the reinvested dividends over the measurement period.
The next progressive measurement of drag on performance is load-adjusted or SEC standardized return. This figure is derived by taking the fund's total return and adjusting for any load the fund might levy. For load structures with multiple breakpoints or time horizons, the highest load or most applicable load is used. For a no-load fund, the SEC standardized return is generally identical to its calculated total return.
Now that we have stripped out the impact of expenses and loads, the next rung downand the real measure of tax drag for the buy-and-hold investoris the pre-liquidation after-tax return. This figure accounts for expenses, loads and interim distributions, which lower the load-adjusted return by the amount of the tax consequences. Taxes on the distributions passed through from the fund are applied at the highest applicable rate. To identify the true tax drag, we need to compare the difference between the SEC standardized return and the pre-liquidation after-tax return.
The last piece of the puzzle puts the investor's entire investment experience into view: post-liquidation after-tax return. This figure accounts for expenses, loads, interim distribution tax effects and tax effects caused by the saleliquidationof fund shares.
With the ATP calculation methodology prescribed by the SEC, negative performance can be used by the investor as a tax benefit to offset gains or to decrease taxable income. As a result, theoretical tax losses are added back to the portfolio's ending value and could cause post-liquidation ATP to be positive, even though the fund's return before taxes was negative. This return figure can be used to show investors the possible tax consequences or tax benefits that can accrue on selling shares. The table above shows an extreme example of the improvement seen in post-liquidation ATP resulting from selling in 2010 the average dedicated short-bias (DSB) fund at the three-year mark, while the progressive drag on performance is shown for the average precious metals equity (AU) fund.
Other gems can be found by combing through the fund's annual report. In particular, tax-loss carryforwards or carryovers can be found in the notes section of the annual or semiannual report. Comparing the published amount with the current size of the fund can give a perspective of when capital gains will once again impact a fund's ATP return.
The two most recent market meltdowns (resulting from the tech bubble in 2000 to 2002 and the credit bubble in 2008) caused equity-related tax issues to go by the wayside; funds had amassed a great deal of realized losses they weren't allowed to pass through to investors but had to keep on their books to offset future gains. After the 2000 to 2002 market decline, in many cases it took at least three years to use up those losses. However, because of the grand scale of the 2008 declines and the subsequent strong equity returns in 2009, 2010, and 2012, we do not expect the current tax holiday will last as long as it did after the prior meltdown.
A last piece of information to check in the annual report is the tax overhang or unrealized capital gains. Tax overhang is defined by many researchers as the sum of undistributed realized capital gains and net investment income and the cumulative total of the unrealized capital gains and losses of the portfolio. These items can be found in the statement of assets and liabilities section of the annual or semiannual report. Tax overhang represents the possible future tax burden a shareholder may realize in the event of total portfolio liquidation. Tax overhang is generally presented as a percentage of total assets under management. Of the tax measures, this ratio is the only forward-looking one.
In our studies of tax efficiency, we note some of the many benefits and pitfalls of tax-efficiency measures. We suggest that none of the measures be used in isolation but be used instead in concert with the different breakouts of performance, in particular pre- and post-liquidation ATP. With these tools in hand, taxable fund investors are better able to narrow their fund choices, make more informed decisions, and add incremental returns to their portfolios.
Tom Roseen is a senior analyst with Lipper. He is the editor and an author of Lipper's
U.S. Research Studies, Fundflows Insight Reports and Fund Industry Insight Reports.