Those Fund Returns May Be Lower Than You ThinkJeff Laderman
Investors reveling in their mutual-fund successes may be in for a shock when they start to prepare for Apr. 15. Their equity funds may be throwing off more taxable income than they think, thus lowering the aftertax return on their investment. And it's not what you make--but what you keep--that counts.
That's why the BUSINESS WEEK Mutual Fund Scoreboard (BW--Feb. 14) now reports aftertax, as well as the standard pretax, total returns. To calculate the aftertax figures, Morningstar Inc., which provides the data for the Scoreboard, starts with the total return--appreciation plus reinvestment of dividends and capital gains. Then, it "taxes" each fund's dividends and capital-gains distributions at the highest federal rates in effect during each year. One exception: For calculations on returns earned since 1991, Morningstar uses a tax rate on ordinary income of 31%--which is used for dividends--even though the rates now go as high as 39.6%.
For estimating taxes, Morningstar also assumes that all capital-gains distributions are long-term, meaning the profits come from stocks held for at least a year. The long-term capital-gains rate has gone up and down over the past decade, but since 1991, it has been capped at 28%. The tax rate on short-term gains, which are profits from securities held for less than a year, is the same as the rate on dividends.
And remember, these aftertax estimates take into account federal taxes only. If you're an upper-income taxpayer and you live in an especially high-tax state such as California, Massachusetts, or New York, your aftertax returns will probably look even worse.
The tax impact varies greatly with the funds--even with those that emphasize growth of capital. Look at the funds that delivered the highest average annual total returns over the past five years: CGM Capital Development, which was the No.2 fund pretax, drops to No.12 after taxes. John Hancock Special Equities A, which was No.8 pretax, jumps to third place after taxes. PBHG Growth, with a 27.3% return, was No.9 pretax, but with a 22.1% aftertax return, the fund doesn't even qualify for inclusion in the top 25.
To compare funds on a tax-adjusted basis, divide the aftertax by the pretax return. For Hancock Special Equities, that's 26.9 divided by 27.5, or 98%. That means over five years, the shareholders didn't have to share very much with the Internal Revenue Service. Compare that with the CGM Capital Development, where the aftertax return was only 84% of the pretax.
AVOIDING INCOME. You can perform this calculation on all equity Scoreboard funds. You'll find many income-oriented funds in which aftertax return is less than 80% of pretax. For instance, Income Fund of America is a top-rated fund with very low risk and an average annual return of 13.5% a year over the last five years. But as the name tells you, this fund's goal is to generate income, and much of what shareholders earned was in the form of taxable dividends. After taxes, Income Fund of America returned only 10.7%.
If you're a high-bracket taxpayer, you should steer clear of such income-oriented funds and head toward the more "tax-efficient" growth funds. But bear in mind: Stocks that pay fat dividends are usually less volatile than those that don't--and the same goes for mutual funds. So if you're trading up to more growth-oriented portfolios, you're probably taking on more volatile funds. Your reward should come in the form of higher aftertax returns. Fidelity Contrafund, Oppenheimer Main St. Income & Growth Fund, and Vista Growth & Income A are a little more risky, but all have the potential for higher returns. In addition, they bring more of their pretax returns down to bottom line. Their aftertax returns are all around 90% of their pretax numbers.
The BUSINESS WEEK Scoreboard can also help with yet-untaxed capital gains. This new feature is an estimate of the percentage of a fund's portfolio that is either unrealized capital gains or gains realized but not yet distributed. Mutual funds don't book gains until they sell securities, but once they are sold, the gains (net after losses) must be passed on to the shareholders. When the portfolio losses exceed gains, the untaxed gains will be a negative number, which is the case with 17 of the funds in the Scoreboard.
Don't automatically shun funds that have high untaxed gains. Indeed, a large number of them may be the result of a buy-and-hold investment strategy that rarely dumps large distributions on shareholders. That number can also swell if a relatively small fund should happen to enjoy a huge runup in profits, as is the case with the Eaton Vance Greater China Growth Fund.
CAVEAT EMPTOR. But once the investing public gets wind of the fund's hot streak, new money typically will start pouring into the fund. That means the fund assets--the denominator in calculating the untaxed gains--will grow faster than the gains, which is the numerator. And untaxed gains as a percentage of the entire portfolio will drop.
But if the untaxed gains figure seems large, and if you're thinking of investing in a fund, then you need to find out if there are realized but undistributed gains in the portfolio. You don't want to buy a fund only to get hit with a large capital-gains distribution just days later. If so, you'll be liable for taxes on the distribution, even though your money was not in the fund long enough to have "earned" it.
If the fund is planning a large capital-gains payout, you should wait until after the distribution date to make your investment. As a general rule, most funds make capital-gains distributions in the fourth quarter. But depending on the fund's fiscal year, they can come at any time.
Digging out untaxed or unrealized gains may take some work. The figures reported in the Scoreboard will change over time, depending on the prices of the stocks, the portfolio managers' trading practices, and the amounts of new cash flowing into the funds. It's not a number that brokers who sell funds or the order-takers answering the 800 telephone numbers usually manage to have on hand. But if the fund representatives are not able to answer your questions, please ask them to put you in touch with someone else who can.
GOLDEN TOUCH. The untaxed gains can help you in making a choice between funds. Let's suppose you were considering Van Eck International Investors, a precious-metals fund with a large, 41%, untaxed gain. Why not instead choose Van Eck Gold/Resources, which has a -9% untaxed gain? The management company is the same, and the funds are similar.
Better yet, why not pick Lexington Strategic Investments? This is a South African gold fund that delivered an astounding 265% return in 1993, but it suffered years of horrendous losses and has tax losses amounting to 122% of its $84.5 million portfolio. If Lexington continues to rack up gains and realize them, you can be sure that for some years to come, those gains will not be coming back to you as taxable distributions.
TABLE: TAXES CAN BITE INTO FUND RETURNS THE TOP 25 BEFORE TAXES Fund Average annual total return* FIDELITY SELECT BIOTECHNOLOGY 30.2% CGM CAPITAL DEVELOPMENT 29.2 TWENTIETH CENTURY GIFTRUST INV. 29.0 THOMSON OPPORTUNITY B 28.9 BERGER 100 28.3 OPPENHEIMER MAIN ST. INC. & GRTH. A 28.2 TWENTIETH CENTURY ULTRA INV. 28.1 HANCOCK SPECIAL EQUITIES A 27.5 PBHG GROWTH 27.3 INVESCO STRATEGIC FINANCIAL SVCS. 27.1 T. ROWE PRICE SCIENCE & TECHNOLOGY 26.8 VISTA GROWTH & INCOME A 26.6 KAUFMANN 26.6 FIDELITY CONTRAFUND 26.5 MFS EMERGING GROWTH B 26.3 INVESCO STRATEGIC TECHNOLOGY 26.1 ALGER SMALL CAPITALIZATION 26.1 VISTA CAPITAL GROWTH 25.8 INVESCO STRATEGIC LEISURE 25.8 FIDELITY SELECT HOME FINANCE 25.1 AIM CONSTELLATION 24.9 INVESCO STRATEGIC HEALTH SCIENCES 24.7 FIDELITY SELECT MEDICAL DELIVERY 24.5 AIM AGGRESSIVE GROWTH 24.3 FIDELITY SELECT SOFTWARE&COMPUTER 24.2 THE TOP 25 AFTER TAXES FIDELITY SELECT BIOTECHNOLOGY 28.4% TWENTIETH CENTURY ULTRA INV. 27.0 HANCOCK SPECIAL EQUITIES A 26.9 BERGER 100 26.7 TWENTIETH CENTURY GIFTRUST INV. 26.6 THOMSON OPPORTUNITY B 26.5 KAUFMANN 26.3 MFS EMERGING GROWTH B 25.8 OPPENHEIMER MAIN ST. INC. & GRTH. A 25.1 VISTA CAPITAL GROWTH 24.7 FIDELITY CONTRAFUND 24.5 CGM CAPITAL DEVELOPMENT 24.5 VISTA GROWTH & INCOME A 24.3 INVESCO STRATEGIC FINANCIAL SVCS. 24.2 T. ROWE PRICE SCIENCE & TECHNOLOGY 24.1 FIDELITY SELECT HOME FINANCE 24.0 INVESCO STRATEGIC TECHNOLOGY 23.9 AIM CONSTELLATION 23.4 INVESCO STRATEGIC HEALTH SCIENCES 23.3 FIDELITY SELECT MEDICAL DELIVERY 23.2 ALGER SMALL CAPITALIZATION 23.1 INVESCO STRATEGIC LEISURE 22.5 AIM AGGRESSIVE GROWTH 22.4 OBERWEIS EMERGING GROWTH 22.3 FIDELITY SELECT TECHNOLOGY 22.3 *Appreciation plus reinvestment of dividends and capital gains, 1989-1993 DATA: MORNINGSTAR INC.TABLE: UNTAXED GAINS LURKING IN MUTUAL FUNDS THE MOST Fund Untaxed gains* HANCOCK FREEDOM NATL. AVIATION 57% CENTURY SHARES 55 LORD ABBETT DEVELOPING GROWTH 51 ADVISORS A 47 ACORN 45 EATON VANCE GREATER CHINA GROWTH 45 SALOMON BROTHERS OPPORTUNITY 43 SENTINEL COMMON STOCK 43 SMITH BARNEY SHEARSON AGGR. GR. A 43 FPA CAPITAL 41 FT INTERNATIONAL EQUITY A 41 VAN ECK INTERNATIONAL INVESTORS 41 FIDELITY OVERSEAS 40 FORTIS GROWTH 39 BABSON GROWTH 38 KEYSTONE CUSTODIAN S-4 37 SCUDDER DEVELOPMENT 37 NEWPORT TIGER 36 PUTNAM OTC EMERGING GROWTH A 36 EVERGREEN 35 FIDELITY SELECT HOME FINANCE 35 SAFECO GROWTH 35 T. ROWE PRICE NEW HORIZONS 35 MERRILL LYNCH DRAGON B 35 59 WALL ST. PACIFIC BASIN EQUITY 34 THE LEAST LEXINGTON STRATEGIC INV. -122% PUTNAM CORPORATE ASSET -104 UNITED SERVICES GOLD SHARES -41 PUTNAM EQUITY INCOME A -38 USAA INVESTMENT GOLD -37 PUTNAM ENERGY RESOURCES -9 VAN ECK GOLD/RESOURCES -9 PUTNAM MANAGED INCOME -8 SUNAMERICA VALUE B -8 ALLIANCE NEW EUROPE A -7 DREYFUS CAPITAL VALUE (PREMIER) -7 PAX WORLD -5 G.T. EUROPE GROWTH A -4 YACKTMAN -4 DEAN WITTER EQUITY-INCOME -3 COLONIAL UTILITIES B -2 PAINEWEBBER EUROPE GROWTH A -1 PRA REAL ESTATE SECURITIES 0 MERRILL LYNCH TECHNOLOGY B 0 INVESCO STRATEGIC FINANCIAL SVCS. 0 VANGUARD PREFERRED STOCK 1 VANGUARD SPECIALIZED ENERGY 1 MATHERS 1 MONETTA 1 INVESCO STRATEGIC UTILITIES 1 *Percentage of assets in portfolio that are unrealized and undistributed capital gains DATA: MORNINGSTAR INC.