A while back, I remember speaking with an industry colleague about a company that had been in the news. He told me that he liked the company’s stock and that, in fact, he had bought it for the mutual fund that he managed. Then he added, parenthetically, “I owned it, then I sold it, then I bought it back.”
This discussion highlights a fundamental challenge for investors, which is that mutual fund managers face incentives that diverge oftentimes from their clients. Specifically, fund managers are graded and compensated for the performance that they deliver before taxes. But, what really matters to fund shareholders is how an investment performs after taxes.
Why this mismatch? Why not evaluate fund managers on their true, after-tax returns? As illogical as it may seem, there is an explanation: Every individual fund shareholder faces their own unique tax treatment. For example, a high-income individual might be in the top tax bracket, while a school or charity might pay no tax at all. And there are circumstances under which an individual might also pay no tax. For example, if you hold a fund in a tax-deferred account, such as a 401(k) or IRA, you are not taxed until you take the money out in retirement. Beyond that, some taxpayers might be in the zero-percent capital gains tax bracket or might have offsetting tax losses. In all of those cases, taxes wouldn’t be a factor, so fund companies have gotten in the habit of largely ignoring taxes.
But what if you do care about taxes? If you’re like most people, you receive a pile of tax forms each year and simply forward them along to your accountant. But, it’s worth taking the time to understand how your investments might be impacting your tax return. Depending upon the types of investments you hold, the impact might surprise you. According to the research firm Morningstar, investors in actively-managed stock funds give up approximately 0.75% per year in taxes. In another study, Robert Arnott of Research Affiliates found that the tax impact can be as much as 2%, or more, depending upon the time period. While these may sound like small numbers, it’s important to view them in context. Historically, stocks have returned about 10 percent annually, and bonds about 5 percent. So, if taxes are subtracting about 1 percent per year, that means that your actual take-home profits are being diluted by 10 to 20 percent. This would be bad enough if it happened in any one year, but if it happened ever year, it would have a very serious impact on your wealth over time. So, unless your investments are held inside a tax-deferred account, such as a 401(k), 403(b) or IRA, it’s really worth paying attention to taxes.
Fortunately, there are some basic steps you can take to be sure you are investing tax-efficiently:
1. If you are considering a mutual fund, you should always check the fund’s prospectus. You can find this document on the fund company’s website. It may be dozens of pages, but just search for the words “Return Before Taxes.” There you’ll see the fund’s performance over various time periods. And, on the next line you’ll see “Return After Taxes on Distributions,” which shows you what the fund’s after-tax return would have been for an individual in the top Federal tax bracket. While that may not precisely describe you, the before- and after-tax figures can tell you a lot about how a fund is managed and how it might impact your tax bill in future years.
2. Another statistic you can check is Morningstar’s “Tax Cost Ratio,” which they calculate for every fund. To find this figure, go to morningstar.com, enter the fund’s name at the top of the screen, then choose the “Tax” tab. If you compare a few funds, you will quickly begin to appreciate the differences.
3. If you’d rather not spend your time doing this research, another approach would be to ask your tax advisor. Accountants are always happy to hear from clients outside of tax season, and it would be a straightforward task for them to tell you the tax bill generated by your investments. I could do this for you too. Importantly, you want to see that number in relation to the overall size of your portfolio. This is definitely the route you will want to take if you own non-publicly-traded investments, such as real estate, venture capital or hedge funds.
4. Finally, and perhaps the easiest way to manage your tax costs: Stick to index funds. Because of their mandate — which is to buy and hold investments, with infrequent changes — most index funds will generate lower tax bills than actively-managed funds whose managers might not think twice about buying, selling and then buying back the same investment all in one year.