It may seem trivial, but fund investors should pay attention to some of those oft-ignored small drags on performance that impede wealth creation over the long hauleven if its just one penny at a time.
For years, many mutual fund investors have been impactedwithout even knowing itby the disconnect between their year-end portfolio statements and their mutual fund 1099-DIV forms that arrive several weeks later. For investors in taxable accounts, the total return in the year-end statement may not be what a portfolio has realized.
From a historical perspective, we have all gotten used to viewing the performance of our funds by using the oft-cited metric of total return. Total return allows simplistic side-by-side comparisons, but it is often overstated. Investors using loaded funds or funds in taxable accounts should use SEC load-adjusted returns and pre- and post-liquidation after-tax performance (ATP) to better assess their funds real returns. These measures take into account the impact loads and taxes have on returns.
For example, over the past 10 years the average fixed income fund posted a 4.56% average annualized total return for the period ended Dec. 31. If one takes into account the impact of loads on the return over that time, the average fixed income funds SEC load-adjusted return declined to 4.48% (just an 8-basis-point decline because of fund loads, since the impact of loads on performance attenuates with time). However, including the impact that interim taxes have on the average fixed income funds return is much more telling. On a pre-liquidation after-tax performance basis (that is, we assume a buy-and-hold strategy and dont liquidate the fund at the end of the period), we see the average fixed income fund returned just 2.78% for that 10-year period (a 170-basis-point difference from the load-adjusted return).
If we take this exercise one step further and compound an initial investment of $10,000 over a 30-year period using a 4.48% return versus a 2.78% return, we see that 170 basis points makes a great difference in the creation of wealth over a long period.
In the example above, we see that the difference between the compounded sum of the load-adjusted return and the pre-liquidation after-tax return for the average fixed income fund over a 30-year period was a whopping $14,410, almost one and half times the initial investment. So, the impact of a 170-basis-point loss each year over a 30-year period can have a significant impact on wealth creation.
For the last 10 years, equity fund investors in taxable accounts (that is, not in some tax-advantaged account) have witnessed a tax holiday of sorts. After suffering monumental realized losses in the equity market from the 2000-2003 dot-com meltdown and the 2007-2008 global financial crisis, equity funds have been able to use the accrued tax-loss carryforwards to offset current year distributionsthus appearing very tax efficient. But after a five-year equity bull market, those tax-loss carryforwards are just about used up. For 2013, the average equity fund surrendered 163 basis points of its return to the tax man, up 126% from 2012s 72-basis-point average one-year tax drag.
Using conservative assumptions, we estimate that taxable mutual fund investors surrendered $29.8 billion to Uncle Sam in 2013 for doing nothing more than buying and holding their mutual funds. That is a 41.9% increase from the estimated tax payments paid by fund investors in 2012 ($21.0 billion). What is so bothersome about this figure is it represents what you and I paid from our taxable accounts for being faithful buy-and-hold investors (doing no active trading).
Here is why this happens. Mutual funds are granted the special ability to avoid triple taxation (that is, paying taxes at the corporate level of the individual company, the regulated investment company [RIC] level, and the investor level) under the Revenue Act of 1936 and subsequent clarifications in Subchapter M of the Internal Revenue Code of 1986. To qualify for this special deduction, RICs are required to pay out to shareholders virtually all of their net investment income and realized capital gains, in addition to meeting other qualifying criteria.
THE RUB FOR SHAREHOLDERS
At the shareholder level, taxable investors are taxed on the net income dividends and capital gains realized by the RIC and on capital gains realized by the investor upon the sale of any appreciated shares of the fund. The shareholder is in control of only one of these taxable events: the redemption of his or her shares. And therein lies the rub: A shareholder may be responsible for taxes incurred by the fund, even though he or she did not sell any shares of the fund.
At present, a shareholder is required by the IRS to pay taxes on all net gains and income dividends realized and distributed by the fund in the calendar year, regardless of the shareholders actual cash receipt of the distribution (many investors have their distributions automatically reinvested back into the fund). That is why its so important for fund investors in taxable accounts to view their year-end fund statements alongside their 1099-DIV forms.
For 2013, distributions from mutual funds increased 47% from those of 2012. Overall, short-term capital gains distributions jumped 64%from $21.6 billion for 2012 to $35.5 billion for 2013, while long-term gains distributions increased a whopping 196%from $72.1 billion to $213.4 billion. For investors in tax-deferred/tax-sheltered accounts, this jump in distributions was of little concern. However, for investors in taxable accounts, being forewarned was being forearmed: One can earn incremental returns by paying attention to tax drag.
Now, dont get me wrong. I am not suggesting we let the tax tail wag the dog. Tax efficiency isnt a panacea on its own. After all, a fund that pays out no capital gains or income distributions and loses money each year would be by definition very tax efficient; however, it would not be a fund we would want to own. But, after we have identified relatively strong-performing funds for our taxable accounts, I am suggesting that by implementing some common-sense strategies, one can add incremental returns to a portfolio over the long haul by keeping an eye on the components of performance drag.
Lets move back to addressing tax efficiency and overall portfolio wealth creation. As Lipper has shown in other papers, tax-conscious investors can use tax-managed funds, exchange-traded funds, index funds and tax-exempt funds to help minimize tax drag on their taxable accounts. Although we have found that over the long haul, paying attention to taxes can make a great difference in ones overall wealth creation, we also need to address the issue of asset location. If investors have the right mix of asset classes, that maximizes upside potential in their portfolio while at the same time lowering risk. Then they can turn their attention to asset placement; that is, the strategic use of taxable versus tax-advantaged accounts to maximize overall portfolio wealth.
We know there is a huge benefit in investing assets in tax-deferred accounts such as 401(k) plans, IRAs and annuity products, namely the ability to earn pretax returns on our accounts until we start making withdrawals during our retirement days. Qualified plans such as traditional IRAs and 401(k)s add another attractive feature; that is, contributions are often fully tax deductible, and with 401(k)s employers frequently match a certain percentage of our contributions. Any amount deferred directly into a 401(k) is exempt from income tax.
With Roth IRAs, Coverdell Education Savings Accounts (a.k.a. Educational IRAs) and annuity products, investments are made after taxes. But these products still provide an opportunity to investors who have maxed out their IRAs and 401(k)s to make tax-deferred investments and to shelter gains, income distributions and investment interest.
VARIABLE HOLDING PATTERN
In most studies addressing asset location decisions, researchers recommend holding taxable bonds in tax-deferred accounts and equities and tax-exempt bonds in taxable accounts, highlighting the higher tax drag of taxable bonds relative to equities. However, in years when tax-loss carryforwards were not so prevalent, not all equity securities were equal; tax drag for equity funds was often as high as 2.5 to 3.0 percentage points each year. Equity funds with low capital gains realization and low to no income distributions were ideal funds to place in taxable accounts; however, high-turnover, heavily leveraged and mixed-asset funds, which pay out relatively large sums of ordinary income, were better placed in tax-deferred accounts.
In conclusion, while we all need to pay our fair share of taxes, as entertainer Arthur Godfrey said, I am proud to be paying taxes in the United States. The only thing isI could be just as proud for half the money. Paying attention to those small drags on performance can greatly benefit taxable investors over the long haul.