Chapter 19. Remember, the Tax Man Cometh
| Jonathan Clements, a columnist for The Wall Street Journal , recently wrote in one of his columns , "Actively managed funds, which have always struggled to beat the market, look even worse if you adjust their performance for taxes." [1]
Paul Royce, Director of the Investment Management Division of the SEC, said in a press release, "Taxes can be the most significant cost of investing in a mutual fund." [2]
By 2001, readers of popular press magazines began to see more and more criticisms of mutual funds with regard to the tax issue, primarily stemming from the sharp drop in the stock market coinciding with the large tax bills on distributions that came due in 2001. [3]
For shareholders, and indeed for all individuals, what really matters is what they get to keep after taxes, not what they earn before taxes. Therefore, whether we are considering mutual funds or some of the alternatives, we always need to ask about the tax consequences of the investment. When we discuss the alternatives to mutual funds in later chapters, we concentrate in particular on the tax advantages that some of these alternatives offer. This is a serious issue that warrants careful investor attention. Morningstar has estimated that mutual funds can lose 25 percent or more of their total returns to taxes. Unlike the situation only four or five years ago, shareholders now have alternatives for dealing with this situation. Separate account management, discussed in a later chapter, gives investors much more control over their tax liability, as does folio investing. This problem has often not been recognized by investors. What happened in 1999 and 2000 awakened a lot of people. In 2001, capital gains distributions hit a record high of $345 billion, but the average stock fund lost 4.5 percent. If you are a stockholder of a corporation, you pay taxes when you sell a stock, and not before. By law, mutual funds must distribute income and capital gains to shareholders annually. Therefore, if you are a shareholder of a fund, the fund cannot keep capital gains and let you pay taxes when you sell the fund. That would put fund shareholders on equal footing with stock investors, allowing them the same opportunity to realize gains when they want to. But such is not the case with mutual funds!
The first point to note is that funds can offset gains with losses ”they cannot pass on their capital losses to the shareholders. Thus, funds can "gather" losses on positions that are not working out and offset these losses with gains on other positions . However, fund managers are compensated on the basis of the pretax returns generated by the fund, so gain “loss tax management is not their first priority. Second, note what happens in these situations. Assume a mutual fund has $10 million in assets, one million shares outstanding, and $1 million in realized capital gains (the fund has sold the shares and has a paper profit, but has not yet distributed the gains). Assume each investor owns 10 shares with a total value per shareholder of $100. Now suppose the fund declares a distribution of $1 per share. The value of each share is $10. On the distribution date, the fund distributes $1 per share to the shareholders. The value of each share declines to $9 because $1 million in fund assets has now been distributed. (We are, of course, for simplicity assuming no change in the value of the underlying portfolio.) Assume all the shareholders reinvest their distributions in additional shares. Each investor now owns 11.111 shares, with the same total value as previously ”$100. However, each shareholder now has a tax liability for that year because they received a taxable distribution. The fact that they reinvested the money in additional shares makes no difference in this regard. The distributions can be received in cash, reinvested in additional shares, or both. As we now know, however, income taxes must be paid annually on these distributions. For that part of the total distributions representing dividends from stocks and interest from bonds other than municipal bonds , ordinary tax rates apply. This means that investors in the highest federal tax bracket could be paying a 38.6 percent tax rate on these dollars. Other distributions are identified by the mutual fund as being short-term or long-term capital gains, and these are taxed at either the ordinary rate or the long-term capital gains rate. If it is a long- term capital gain, the distribution receives favorable tax treatment, generally at a 20 percent tax rate. Mutual fund shareholders need to be aware that the exchange privilege , or the ability to exchange shares of one fund for shares of another, generates a taxable event. For tax purposes, exchanges are treated as if the shares in one fund have been sold and the proceeds used to purchase shares in another fund. Thus, you as the shareholder must report any capital gain from such an exchange of funds on your tax return. [4]
Joel Dickson of the Vanguard Group has estimated that taxes on the distributions to shareholders (dividends and capital gains) reduce the returns on the average domestic equity mutual fund by almost 2.5 percentage points annually. In testimony before the Commerce Committee of the U.S. House of Representatives, Dickson made the point that for most investors, taxes constitute the largest cost when investing in a mutual fund. He also noted the wide variation among funds in terms of the annual tax bite ”from zero to more than seven percentage points a year. [5]
An average reduction of 2.5 percentage points a year in the shareholders' effective return is obviously a significant loss. Much of this reduction stems from the fact that the shareholder has no direct control over the realization of these gains and losses. The only decision he or she can make is when to sell shares already owned, which triggers yet another gain or loss for tax purposes. However, it gets worse. In 2000 mutual funds experienced a record-breaking year ”for taxes. It is estimated that funds distributed an aggregate of $345 billion in taxable capital gains to shareholders, which is a record. The whammy comes about because most funds suffered a loss in 2000 ”remember, the Nasdaq index was down 59 percent and the S&P 500 Index was down 10 percent. Many funds had to sell shares to meet redemption demands as investors bailed out, thereby generating taxable gains. When all was said and done, at the end of the year investors suffered a loss on the value of their shares while facing large tax bills on the distributed gains. As a case in point, the Van Wagoner Emerging Growth Fund showed a 291 percent return in 1999. In 2000 it had a 21 percent decline. For the year, the fund distributed $5 per share in capital gains. But wait, some say. There is a new trend afoot ” tax-managed funds . These funds promise to trade efficiently and use optimal accounting techniques to minimize taxable gains distributed to shareholders, and some do. However, at the end of 2001, only about 66 funds billed themselves as tax-managed, and the total assets of these 66 funds amounted to only $35 billion, a small fraction of the nearly $7 trillion in mutual fund assets. Furthermore, their track records are short: Only half of these funds have been around at least three years. As for accounting techniques, it is true that a number of funds use smart accounting techniques to minimize tax impact. Chief among them is highest in, first out (HIFO). Under this technique, when a fund manger sells some but not all of a position, he or she sells the shares for which he or she paid the most, and hence the taxable gain is smaller. The largest mutual fund companies use HIFO, but some large funds do not. Examples of nonusers include American Express, Morgan Stanley, and Oppenheimer Funds. Investors should check on this with their own funds. It could be costing you money! Ironically, it might be smart to buy funds after they have suffered these large losses if you believe that the fund has potential for the future because of its objective, managers, track record, or other factors. A fund that suffers large losses removes all of its gains for some future period. As it trades and realizes these gains, they are not taxable. Therefore, the fund can appreciate in price without passing on taxable distributions to the shareholders. Based on what happened in 2000, this is the case for a number of funds. Even a tax-efficient fund cannot pass capital losses through to shareholders. There are times when having capital losses would be a help on your income tax returns, but you will have to own individual stocks directly if you want to use the capital losses. Things are changing with regard to mutual funds and taxes. Funds now publish tax-adjusted returns, allowing investors to better understand the implications of the fund's actions. Many more shareholders now understand the implications of a mutual fund's activities with regard to portfolio turnover. For a fund to achieve tax efficiency, in general the portfolio turnover should be low, near 20 percent. Investors who understand the importance of tax efficiency for a mutual fund have two choices. They can buy and own actively managed tax-managed funds, or they can buy tax-managed index funds. Vanguard offers such index funds, as does Schwab and other companies. It should be noted that even for these funds things can get out of line. A fund that is striving to avoid selling stocks with capital gains may track its underlying index less well. However, with new money flowing into the fund, this should be less of a problem.
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Pages: 94