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 performance—sometimes double or triple the drag of fund expenses and loads—Congress 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.