As Stock Market Returns Shrink, After-Tax Results Gain Importance

Taxes are the single largest expense for mutual fund investors in taxable accounts. They eat up more of your gains than administrative expenses, marketing costs or trading fees do.

Yet, throughout most of the ‘90s bull market, the whole issue of taxes--and their impact on mutual fund investors--never really caught fire. That is, until recently.

Last week, Vanguard Group, the nation’s second-largest mutual fund company, said it would begin publishing “after-tax” performance results for 47 of its funds in addition to the performance figures it already reports.

In other words, shareholders in Vanguard’s taxable accounts will now see two total return figures--one representing pretax gains, and another representing real returns, once taxes on capital gains and dividend income are factored in.

Now, says Rande Spiegelman, manager of KPMG’s personal financial planning services in San Francisco: “I think taxes are going to become more of an issue going forward.”

The Chicago-based publication Morningstar Mutual Funds began listing after-tax returns for the funds it tracks in 1993. Back then, though, few cared. So what changed? Have you checked out the stock market recently?

“Investors don’t care about losing some of their returns to taxes when they’re enjoying 25% returns in their funds,” Spiegelman says. “But if we’re heading into a period where returns will be normal or subnormal [relative to recent averages]--like 8% or 9% or lower--then taxes and fees are going to become very noticeable.”

More than 10 months into this year, the average diversified U.S. stock fund is up just 5%. The average fund that invests in large value-oriented stocks is showing losses of about 1%.

Now, taxes take away about 2.5 percentage points of a fund’s total returns, on average, according to a recent Vanguard study. Not 2.5%, but 2.5 percentage points.

You do the math.

To be sure, many of us are investing in mutual funds through tax-deferred retirement accounts such as employer-sponsored 401(k)s and in IRAs. In fact, about 34 cents of every dollar in a mutual fund sits in a tax-deferred plan. For stock funds, it’s more than that--nearly 45 cents of every dollar is tax-deferred. Obviously, in this setting, taxes aren’t a concern--at least, not until we retire and draw down the money.

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But the majority of mutual fund shares and shareholder assets are still held in taxable accounts.

And in this setting, “the pretax returns that most of us track is in fact really not that relevant,” says Joel Dickson, a principal with Vanguard’s portfolio review group and a leading expert on the effects of taxes on mutual funds.

Indeed, according to Vanguard, the average U.S. diversified stock fund delivered annualized returns of 16.1% in the 10 years ended Aug. 31, 1999. That’s pretax.

Once you factor in taxes, though, the actual returns investors took home fell to just 13.6% (assuming the top federal tax bracket in place at various times throughout this period, but not including state or local taxes).

That gap represents roughly the same difference between the pretax returns of a four- or five-star Morningstar-rated large-cap stock fund and a three-star large-cap fund. (How many of us go shopping for a three-star-rated fund?)

Yet few investors factor this in when making their buy, sell or hold decisions.

Up until now, even if you wanted to, it was difficult to do--unless you subscribed to Morningstar Mutual Funds. However, there’s a move afoot to require that all funds report both pretax and after-tax returns, just like Vanguard is doing voluntarily.

The Mutual Fund Tax Awareness Act of 1999, co-sponsored by Rep. Paul Gillmor (R-Ohio) and Rep. Edward Markey (D-Mass.), would require the Securities and Exchange Commission to revise its regulations to improve methods for disclosing the after-tax effects of dividend and capital gains distributions.

The legislation, now in committee, has the support of the Investment Company Institute, the fund industry’s chief trade group. ICI President Matthew Fink points out, though, that the SEC does not need legislation to revise its rules and to begin requiring after-tax disclosures. SEC officials are studying this issue.

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Meanwhile, Vanguard officials are considering developing a Web-based tax calculator which would allow investors to plug in their actual federal, state and local tax rates to determine their personal after-tax returns. (In its annual reports, Vanguard calculates after-tax returns based on the top federal marginal tax rate--and without state or local considerations--just as Morningstar does.)

In the meantime, what’s an investor to do?

* If you have access to Morningstar Mutual Funds (which is available at many large public libraries), consider a fund’s after-tax returns in addition to pretax numbers when assessing a fund in a taxable account. In a tax-deferred setting, pretax returns are sufficient, analysts say.

* Know which types of funds are inherently tax-efficient, and which aren’t. In general, Dickson says, large-stock funds are more tax-efficient than funds that invest in smaller companies. Why? Typically, as small stocks grow to become large ones, small-stock fund managers are forced to sell them, triggering capital gains taxes. On the other hand, large stock fund managers are generally allowed to hang on to their winners without realizing gains.

In addition, growth-oriented stock funds tend to be more tax-efficient than value-oriented portfolios, Dickson says. That’s because value stocks (beaten-down or out-of-favor companies typically in mature industries) tend to throw off more dividend income, taxed at normal income tax rates. Also, value stock fund managers typically are forced to sell shares of beaten-down companies as they recover and become growth stocks. Growth fund managers, on the other hand, can hang on to their winners for years--though not all do.

Which brings us to another indicator of tax efficiency: Turnover rates. This figure represents how frequently a fund sells and replaces its entire portfolio. For instance, the average U.S. diversified stock fund has a turnover rate of 96%, indicating that virtually all of the fund’s holdings are sold and replaced in a year’s time. Funds with low turnover rates rarely sell their holdings, which means they rarely realize taxable gains.

* When in doubt, go with an index fund. These passively managed portfolios simply buy all the stocks in a particular market benchmark, such as the Standard & Poor’s 500 blue-chip stock index, and hold them. By holding stocks, these funds keep their turnover down and taxes low.

For instance, Vanguard founder John C. Bogle Sr. recently compared the returns of the S&P; 500 index and actively managed stock funds. From 1981 to 1996, the average actively managed stock fund delivered pretax returns of 14.3%. But through taxes, investors lost 2.5 percentage points of that, leaving them with returns of 11.8%.By contrast, the S&P; 500 index delivered annualized returns of 16.7% and lost just 1.6 percentage points of that to taxes, leaving after-tax gains of 15.1%.

* If you prefer actively managed funds, consider a so-called “tax-managed” funds. These funds are mandated by prospectus to consider taxes in the day-to-day management of the portfolio. According to Morningstar, there are now 68 tax-managed funds, with nearly $21 billion in assets.

Be warned though: The majority of these tax-managed funds invest in large stocks--the very group that Dickson says is relatively tax-efficient to begin with. And only a handful invest in value stocks, which are relatively tax-inefficient.

* Times staff writer Paul J. Lim can be reached at paul.lim@latimes.com.