If you have owned mutual funds over the past decade, you've probably chalked up what may look like some pretty fat gains. After all, the average annual return for the past 10 years comes to a nifty 11.8%. But before you pat yourself on the back for being such a savvy investor, take the time to examine a critical element in evaluating your fund's investment performance: taxes.
Most people--including the entire mutual-fund industry--judge a fund before considering the taxes shareholders will have to pay, which could be a big mistake in these days of higher income-tax rates. The difference between pretax and aftertax returns can be startling, depending how much the fund relies on dividends and interest and how frequently the fund trades its stocks.
If you're in the highest tax bracket, returns on your equity fund could be about 25% to 30% lower than you think--and that's just taking federal income taxes into account. Roll in state and local bites, and those returns may look even less enticing. Moreover, ranking funds by their aftertax returns can send leaders to the back of the pack and turn laggards into stars.
At a time when investors are pouring money into mutual funds in record sums--$69.8 billion in equity funds and $73.5 billion in bond funds through July of this year alone--there isn't much evidence that they're taking taxes into account. "I can't tell that investor behavior is changing much because of higher taxes," says Neal Litvack, an executive vice-president of Fidelity Investments. "Maybe it hasn't sunk in yet."
DRAMATIC SHIFTS. Indeed, if investors focused on taxes, says Litvack, they would invest more in tax-exempt municipal-bond funds and less in taxable bond funds. In stocks, he adds, they're choosing conservative funds that generate dividend and interest income--taxable at rates as high as 39.6%--rather than more growth-oriented funds that aim for long-term capital gains, on which the tax is capped at 28%.
But if investors haven't yet caught on to the potential impact of taxes on their investments, you can't blame them: There's little information to go on. Most fund-ranking systems use pretax total returns, since they are the only numbers the funds report. And the growing number of fund investors with individual-retirement and other pension-type accounts, such as the Fidelity Retirement Growth Fund that caters to pension accounts, need not worry about aftertax returns now. They're not paying taxes anyway. But most money in funds is taxable, and analysts and academics are starting to look at aftertax returns. What they're seeing puts funds in a new light.
Stanford University economists Joel M. Dickson and John B. Shoven studied pre- and aftertax returns for 62 mutual funds from 1963 through 1992, and they found some dramatic shifts. The Franklin Growth Fund, for instance, was in the bottom 20% of the list based on pretax returns. But when Dickson and Shoven adjusted the return for the taxes that the highest-income shareholder would have paid, the fund's relative ranking jumped into the top 40%. Likewise, the economists found several funds that dropped significantly in the lineup after taxes. Dickson does not advocate choosing funds solely by past performance, but, he says, "investors need more information about tax effects to make informed decisions."
Indeed, Morningstar Inc., which provides the data for BUSINESS WEEK's Mutual Fund Scoreboard, has started reporting aftertax returns on funds. Be forewarned that your aftertax returns may differ from Morningstar's, because it assumes the shareholder is in the highest U.S. income-tax bracket in effect each year. Nor does Morningstar take state and local taxes into account.
To see how taxes can affect fund returns, consult the table at right. Look at Fidelity Magellan Fund and the column showing 10-year average annual returns. That figure includes the fund's appreciation and assumes the investor reinvested the dividends and capital gains--as most do. Magellan's 10-year average annual total return for the period ending Aug. 31 was 18.5%. But after taxes, that's just 15.4%. Roughly 17% of the return was eaten away in taxes. If you ranked these 50 funds by 10-year pretax returns, Magellan would be No.2. After taxes, it's No.3.
Not too great a difference. But consider Vanguard/Windsor Fund: With a 15.6% average annual pretax return, it's No.16 of the 50 for the 10 years. But after taxes, its position changes markedly. With an 11.3% return, Windsor drops to 30th place. In sharp contrast, Vanguard Index 500 Trust, with 14.6%, is No.27 pretax. But with a 12.4% aftertax return, the fund jumps to No.19.
SITTING PRETTY. Aftertax rankings differ from traditional rankings because of the way tax laws affect mutual funds. Basically, mutual funds make money two ways: from interest or dividends paid by the securities it owns, and investing in securities that go up in price. The law makes mutual funds distribute their net income and proceeds from profitable security sales, or "realized" capital gains, and they must do so before the end of the year in which profits were earned. Funds can also dump their losers and use those losses to offset some of those gains.
How much capital gains the fund generates depends, of course, on the overall state of the stock market, but also on how frequently the fund trades. "Buy-and-hold" funds, or those with "low turnover," typically let their profits ride and trade infrequently. They generally have lower capital-gains distributions and higher aftertax returns than a fund that trades more frequently. That, says John C. Bogle, chairman of the Vanguard Group, helps to explain why the Vanguard Index 500 Trust--which doesn't trade its portfolio--beat the more actively managed Windsor Fund after taxes. The other reason: Windsor often buys out-of-favor stocks with higher-than-average dividends and so generates more income than the index fund.
Indeed, the components of a fund's return are as important as the return itself. Conservatively run funds, such as income funds, equity-income funds, and balanced funds, make interest and dividends a priority, and these are taxed at the shareholders' top rate. That explains why the 10-year aftertax returns on such funds as Income Fund of America, Fidelity Puritan, and Fidelity Equity-Income are roughly one-quarter less than their pretax returns.
Now look at Twentieth Century Ultra Investors, which invests in fast-growing companies that rarely pay dividends. The fund has distributed only 21 in income over the past 10 years. During the same time, it tended to hold on to its winners and thus minimized its capital-gains distributions. As a result, Ultra's aftertax return of 14% was 89% of its pretax return, 15.7%. For the past three years, its pretax and aftertax returns are virtually the same.
LESS IS MORE. Ron Neville, chief financial officer at Twentieth Century Mutual Funds, says the Ultra fund isn't deliberately trying to avoid capital-gains distributions. That's just the outcome of its investment style, which focuses on companies with accelerating earnings. "If a stock disappoints us, we sell it and don't hang on," he says. So the fund usually has realized losses that can be used to shelter gains.
While comparing pretax and aftertax returns provides insight into a fund's past, another calculation can be a window into the future: "estimated tax liability." This figure, which Morningstar now reports as well, sizes up unrealized capital gains in a portfolio and expresses them as a percentage of fund assets.
In theory, at least, the more unrealized gains in a fund, the greater the chance that they will be realized. That's O.K. for longtime investors who participated in the appreciation of those stocks. But what happens if an investor buys a fund with a large tax liability, and the fund sells those profitable stocks tomorrow? The new investor who paid top dollar for those stocks when investing in the fund, will be hit with the same taxable distributions as the investor who was in for years.
Funds with big tax liabilities--or "embedded gains"--can surprise investors, especially if the portfolio manager decides to start taking profits because he or she detects a change in the market or wants to change the fund's strategy.
But many funds carry unrealized gains on their books for years, if not decades. The Pioneer Fund, for instance, has a huge 63.4% of its portfolio in unrealized gains. Pioneer also is the quintessential buy-and-hold fund: Its 600,000 shares of Greif Brothers Corp., a container manufacturer, were acquired 40 years ago for $521,000 and now are worth nearly $24 million. Nor is Pioneer quick to take profits on the rest of its portfolio. Its average turnover is 15%, vs. 80% for the average equity fund. So it is unlikely that the fund will start dumping stock and incurring capital-gains taxes for its shareholders.
GOLD DIGGERS. Perhaps even more interesting--and potentially more profitable for investors--is the concept of "embedded losses." These are the negative tax liabilities, or tax-loss carryforwards, that some funds have on their books if they have made poor investments. They build up because mutual funds can't distribute capital losses to shareholders. Funds can, however, hold on to them for eight years and use them to offset gains.
Not surprisingly, the funds with the largest negative liabilities are gold funds, which despite their shining 1993 performances have been big losers for past decade. Even if Lexington Strategic Investments, the year's top-performing fund, keeps up its torrid, 118% year-to-date return, its shareholders won't have to pay taxes on its capital gains for years. It has tax losses amounting to more than twice the assets in the fund. If you're convinced a beaten-up type of fund is about to rebound, buying one with tax-loss carryforwards can be a smart move.
Of course, in choosing equity mutual funds, taxes should not be the primary consideration. Investors should select the funds that best fit their financial goals and ability to take risks. Still, with tax rates on the rise, factoring in the impact of taxes is a must for the sophisticated investor.