The SEC has a proposed rule on the docket that would require mutual fund companies to report their annual returns after capital gains taxes. The method proposed would be the "worst-case" scenario, so that investors will know what their real returns are. Perhaps this added visibility will shine some light on one of the least understood drags on mutual fund returns: portfolio turnover.
I'll bet the vast majority of mutual fund investors have no idea what their returns are. Oh sure, you receive your annual and quarterly prospectuses, with the one-, three-, and five-year returns. You might even have Quicken set up to track appreciation and long- and short-term capital gains. Click on a button and it generates a sweet little report with your Internal Rate of Return (IRR) for your mutual fund holdings. Very helpful.You can even take these returns and compare them to the returns of the S&P 500, the benchmark The Motley Fool believes you should use to gauge the performance of all your investments.Did your fund portfolio beat the benchmark? Congratulations! You are in the decided minority since, according to Lipper Associates, over time more than 80% of all actively managed mutual funds fail to do so once all management expenses have been netted out. To be fair, even the indexed mutual funds, such as the Vanguard 500 Index Fund (Nasdaq: VFINX), fail to match the index exactly due to their (minuscule as they might be) expenses, and inefficiencies from having to purchase real instead of theoretical stocks. So, those of you with mutual funds that beat the returns of the S&P 500 over the long term (the only term that matters) have something to be very proud of.
There's one additional problem with mutual funds that transcends the expenses related to active management (i.e., trading costs, front- and back-end loads, advisory fees, super sweet advertising campaigns, lunch at the best tables in New York and London, and all of the other expenses incurred that you pay for). This problem is called taxes. Federal Freaking Taxes. Unless your fund returns are net of all expenses and all taxes, then your gains are going to be more and more horribly overstated over time.According to the SEC and the Liberty Funds Distributor, stock and bond fund investors paid $34 billion in capital gains taxes in 1997, and annually more than 15% of all mutual fund gains are wiped out due to these taxes. This is assuming that there is a gain. Even if a fund value declines, if the fund manager has sold appreciated assets the investor can be socked by Uncle Sam for a few more percentage points.The legislation that made mutual funds legal in the United States back in 1940 also provided that the capital gains for those mutual funds would have to be paid on an annual basis.
One of the best arguments for investing for the long term is that, as long as you hold your stocks, you do not have to pay taxes on them.With mutual funds, your propensity to buy or sell is less relevant as far as the government is concerned. The fund company, with its buy and sell decisions, must distribute the tax liability to its investors every year. So, if a fund holds a company for less than 12 months, you are taxed on the portion of those gains attributable to your holdings at your ordinary income level, which is as high as 39.6%.You will not find any mention of tax-adjusted returns anywhere in your mutual fund literature, unless you are very fortunate.
In some ways this is understandable, as mutual fund companies have no way of knowing what your overall tax levels are. Still, the impossibility of perfection should never rationalize doing nothing.In the last few years, the Securities and Exchange Commission (SEC) has done much to standardize the performance reporting methods for mutual fund companies. I believe that adding a post-tax provision for "pre-liquidated" fund accounts (i.e., those that investors continued to hold through the year without selling), even if it is based on average tax rates, would enhance investors' understanding of the expenses associated with holding mutual funds.However, little has been done to address reporting mutual fund returns on a post-tax basis. The result has been galling. According to Morningstar, the all-fund average annual turnover is 103%. This means that, on average, not a single share that a portfolio starts with on the 1st of January will be there at year's end, and another 3% of the shares that were bought during the year will also have been traded out.
For every trade at a gain, people who have these funds in a taxable account get socked with a bill from the guv'ment.How crucial is the difference? After all, if we are to believe the ads we see in print or on television, plenty of mutual funds are performing way better than the S&P 500. So what if I give up a few percentage points, because I'll still be way ahead, right?Well, first and foremost, "past performance does not guarantee future returns." In some ways, recent outperformance could cause after-tax underperformance in the present and near future. Because so many mutual funds are holding grossly appreciated equities from the past five years (an assumption that flies somewhat in the face of the turnover statistics cited earlier, but bear with me), the post-tax returns for shareholders late to the game will be hindered by the huge tax bills generated by the sale of these equities.
So, investors who came into last year's hot fund too late will get the same tax bill that the long-term holders get, but without the benefit of the actual run up.Annual returns are a notoriously slippery concept. The reality would be simpler if everyone bought and held throughout the year, but that is neither practical nor necessarily beneficial. Investors should be investing to maximize their long-term returns, not to make calculating those returns any easier.Mutual fund companies have been given a free pass from mentioning the after-tax effect of their portfolio management policies. But if capital gains taxes are not a direct expense, what are they?Tax efficiency is one of the holy grails for Foolish investors.
Each bite taken out of a portfolio by Uncle Sam is a lost opportunity, compounded over time. A $1,000 tax bite, if allowed to compound over time, corresponds to an actual opportunity cost of $2,800 after 10 years, $8,100 after 20 years, and a whopping $22,900 after 30 years, compounding at the average historic rate of return for the S&P 500. Currently these are gains that mutual fund companies get to take credit for, but their investors never see. Let's take it a little deeper. Using the average historic returns of 11% per year, if you invest $2000 per year in a tax efficient way, after 30 years you would have a portfolio worth $443,000.
But take a tax bite of only 15% out of those returns per year, and the total portfolio is only worth $271,000.Fortunately, the SEC has a proposed rule on the table that would alter mutual fund reporting requirements to have returns include pre-liquidated tax effects. According to Paul Roye, the SEC's Investment Management Division Director, staff are "very close" to recommending this proposed rule to the commissioners for adoption. For the sake of increased reporting quality and a more informed investment community, I believe this rule to be a positive move by the SEC.Fool on!Bill MannTMFOtter on the Fool Discussion Boards
Correction: In the Fool on the Hill column from October 20, 2000, "Copper Mountain Low," we originally quoted from an interview with Copper Mountain CEO Rick Gilbert, which incorrectly stated third-quarter earnings would come in at 50% above the previous quarter.
The figure should have been 15% and the column has since been amended.
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source: http://www.fool.com/news/foth/2000/foth001101.htm
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