Taxes

A third issue is taxes, which can be a real impediment for investors because they give up control with regard to portfolio transactions when they purchase mutual funds. Funds are required to distribute their income and realized capital gains annually, and investors with taxable accounts must pay taxes annually on these distributions.

By and large, mutual funds have not been managed on the basis of sensitivity to investor needs when it comes to taxes. Instead, mutual fund managers are judged and rewarded on the basis of their overall performance, and if they can enhance this performance by more rapid trading of their positions , which can generate taxable distributions for the shareholders, so be it. Thus, the recognition of capital gains, on which shareholders pay taxes, is solely at the discretion of the fund manager. John Bogle has been quoted as saying, "The fund industry has been run with tax blinders on." ^[2]

^[2] See Jonathan Burton, "Afterglow," Bloomberg Personal Finance , April 2002, p. 58.

For those investors who hold mutual funds in tax-deferred retirement accounts, the issue of taxes is not currently important. Of course, when funds are finally withdrawn from such an account, taxes will be of critical interest.

For investors who hold mutual funds as taxable investments, taxes are, or should be, a primary concern. One of the big topics of discussion these days is tax efficiency , which refers to how much of the fund's returns investors actually get to keep by the time they pay taxes on any distributions from the fund.

Consider the Clipper Fund, a five-star rated fund with a style designated as large value. Although the fund lost 2 percent in 1999, it had strong performance in the difficult markets of 2000 and 2001, with returns of 37.4 percent and 10.3 percent, respectively. Its five-year annualized return through early March 2002 was 17.38 percent. However, its computed tax efficiency ratio on the Morningstar Web site has averaged about 80 percent for the last few years . This results in an after-tax return of about 80 percent of the 17.38 percent annualized return, or approximately 13.90 percent. These are still good returns, but not as good as they first appear.

In contrast, Muhlenkamp is a five-star rated fund with a style designated as midcap value. This fund has also done well in recent years, with a five-year annualized return of 14.71 percent (through early March 2002). Its tax efficiency, however, is approximately 97 percent. Therefore, its estimated after-tax return would be approximately 14.27 percent. The gross returns might have been lower compared to the Clipper Fund, but the net returns (the after-tax returns) could well be higher.

Clearly, investors need to pay attention to the issue of taxes when it comes to their mutual fund investments. It is now possible to buy mutual funds that are specifically designated as tax efficient. However, it is also possible to buy alternative investments that deal directly with tax issues in a manner that is very favorable for investors. We consider these alternatives later.

Note that the situation with regard to disclosure of information concerning the tax situation has changed recently. As of 2002, mutual funds must disclose certain calculations concerning taxes in their prospectuses. Specifically, they must show two standardized measures of performance after taking taxes (calculated at the highest marginal tax rate) into account. Unfortunately, for the most part funds do not have to include these calculations in their advertisements, which is what most investors look at, as opposed to a prospectus . ^[3]

^[3] The exception occurs for those funds designed to be tax efficient.