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Mutual Fund Tax Efficiency
by Craig L. Israelsen
University of Missouri-Columbia
From Financial Planning Magazine, December 2000. Reprinted with permission.
utual fund performance is commonly measured in gross (i.e. pre-tax and pre-inflation) returns. Unlike inflation, the impact of taxes on equity returns varies widely among investors. While some investors have a high marginal tax rate, others have a very low one. Inflation, on the other hand, is more or less uniform in its effect upon equity returns and its impact cannot be delayed or avoided. In contrast, investments in tax-sheltered accounts (e.g. 401k and 403b) and tax-exempt accounts (e.g. Roth IRA) can delay or eliminate taxation. In short, the impact of taxes B as a component of total return B is much more manipulable than is the generalized impact of inflation.
Perhaps this difference between inflation and taxes explains why we have Atax-managed@ mutual funds but very few, if any, which claim to be Ainflation-managed@ funds.
As described by Morningstar, Atax efficiency (which excludes additional gains, taxes, or tax losses incurred upon selling a fund) is derived by dividing aftertax (or tax?adjusted) returns by pretax returns. The highest possible score would be 100%, which would apply to a fund that had no taxable distributions...@. Tax efficient investing is hardly a new concept. Indeed, tax efficiency is one of the primary reasons why an investor would shun mutual funds in favor of individual securities.
For instance, an investor in single stocks can control the timing of sales, and therefore the timing of capital gains taxation. Fund investors are at the mercy of the fund manager with regard to the timing of capital gains distributions declared by the fund. Mitigating the tax efficiency advantage of individual stocks over mutual funds have been two phenomenon: (1) the increased availability and usage of tax sheltered products, most notably the 401(k), 403(b), and IRA, and (2) the decline of capital gains tax rates in recent years.
In spite of the increased usage of tax-sheltered accounts, and concomitant with growth in the overall number mutual funds in recent years, there has been an increase in the number of equity funds with the descriptor Atax-managed@ in their name. As of August 31, 2000 there were 2,799 distinct, domestic equity funds in the Morningstar Principia Pro database. Of that total, 39 funds had the words Atax-managed@ or equivalent terminology in the name of the fund. Other terms included Atax-strategic@, Atax-sensitive@, Atax-aware@, Atax-efficient@, and Atax-smart@. There are undoubtably other funds which have as their mandate the goal of tax efficiency, however in this study only those funds which included a clear reference to tax-management in their title were included.
The average inception date of the 39 Atax-efficient@ funds was 1997. The average inception date for the other 2,760 funds was 1990. This suggests that domestic equity funds designed specifically to be tax-efficient (as determined by funds labeled as such) is a recent trend. Indeed, of the 39 Atax-managed@ funds 37 came into existence after August 1994.
The increase in the number of tax efficient equity funds is somewhat intriguing inasmuch as mutual funds utilized in retirement accounts (401(k), 403(b), IRAs, etc.) do not stand to benefit from increased tax efficiency, at least not during the years in which money is being invested. Only non-tax-deferred investment accounts benefit immediately from increased tax efficiency. Therefore, the increased popularity of tax efficiency (both by consumers and providers of funds) is probably proportional to the amount of money invested in non-tax-sheltered accounts. This would suggest that despite the huge volume of money going into tax-deferred accounts, the cash flows moving into regular taxable accounts warrant the introduction of 37 new Atax-managed@ domestic equity funds within the past six years.
Having established that Atax-managed@ equity mutual funds are growing in number, this article will specifically examine how tax efficiency varies within the Morningstar Style Box. As seen in Figures 1 and 2, the tax efficiency of equity funds is consistently higher as one moves from value to growth. (LV = large cap value, LB = large cap blend, and so on). When moving from large cap to small cap the tax efficiency of these equity funds tends to decline, at least during the 3 and 5 year periods. Over the 1 year period, small cap funds had higher tax efficiency than comparable large cap funds across each of the three styles (Value, Blend, Growth). The sample of funds which generated these results consisted of 1,043 domestic, distinct portfolio equity funds with at least 70% of their portfolio in U.S. stocks and no more than 10% in non-U.S. stocks. The number of funds within each of the nine Morningstar Style Boxes is shown in Figure 1.
From Figure 3 it is evident that the highest tax efficiency, ranging from 85.5% to 89.3%, was achieved by growth funds (of all sizes) and by large cap blend (LB) funds. (Blend referring to a mixture of value and growth stocks). Mid and small-cap blend funds, along with large cap value (LV) funds, produced moderate tax efficiency in the mid 70% range. Midcap value (MV) and small cap value (SV) funds were the least tax-efficient in this sample of equity funds over this particular three year time frame.
There are several important tactics in generating a tax-efficient equity portfolio. First, minimize dividend yield. Second, minimize portfolio turnover. Third, offset gains with losses. As shown in Figures 4 and 5, there are opposing forces at work. First, let=s look at Figure 4. The shaded areas are opposite those in Figure 3 B which is as it should be. Value portfolios tend to have higher dividend yields and therefore lower tax efficiency. In Figure 5, the darkest shading is associated with growth funds, representing higher portfolio turnover. Generally speaking, higher turnover will be associated with lower tax efficiency B at least in theory. And yet, as seen in Figure 3, growth funds tend to have higher tax efficiency.
One possible explanation is that the dividend effect (high dividend = low tax efficiency) is more powerful than the turnover effect (high turnover = low tax efficiency). Said differently, a high dividend yield cannot be negated. It will lower a fund=s tax efficiency, period. Conversely, high turnover may or may not lower the tax efficiency of a fund depending upon how successful the manager is at washing gains against losses. Within this sub-set of funds being analyzed, it would appear that, indeed, the dividend effect is more powerful than the turnover effect.
To conclude, tax efficiency may be a secondary goal for many investors. Their primary goal will likely be either safety of principal or growth of principal. This is an important realization inasmuch as there is little satisfaction in owning a tax efficient fund which generates very poor gross returns. The best of all worlds is, of course, a fund which generates high returns both before and after tax. In recent years, that best world has been made up primarily of growth funds.
However, in a face of a market downturn capital gains which have been accumulating in a growth fund portfolio may be realized as the manager sells appreciated securities to capture gain and/or create liquidity. In such circumstances, the turnover effect (i.e. capital gains which outweigh capital losses) may overpower the dividend effect, which will ultimately lower the tax efficiency of growth funds. So, while tax efficiency is clearly a matter of style, it=s also likely a function of timing.
Figure 1. Tax Efficiency (as of 8/31/00)
Equity Style
(number of funds in parenthesis)
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1 Yr Average
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3 Yr Average
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5 Yr Average
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Large Value (n=260 funds)
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73.8%
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74.4%
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82.8%
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Large Blend (n=193)
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87.1
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86.7
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87.7
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Large Growth (n=166)
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91.8
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89.3
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88.8
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Mid Value (n=87)
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79.4
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65.8
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79.3
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Mid Blend (n=21)
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85.6
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76.5
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81.7
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Mid Blend (n=21)
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85.6
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76.5
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81.7
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Mid Growth (n=124)
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91.2
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86.5
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86.0
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Small Value (n=61)
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85.3
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62.6
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78.7
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Small Blend (n=41)
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91.3
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74.4
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82.4
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Small Growth (n=90)
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92.4
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85.4
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84.9
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Figure 2. Tax Efficiency over Three Time Frames
Figure 3. Three Year Tax Efficiency (%)
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Large
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74.4
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86.8
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89.3
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Medium
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65.8
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76.5
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86.5
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Small
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62.6
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74.5
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85.5
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Figure 4. Average 12 Month Portfolio Yield (%)
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Large
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.90
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.28
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.06
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Medium
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1.43
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.26
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.09
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Small
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1.02
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.47
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.13
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Figure 5. Average Annual Portfolio Turnover Ratio (%)
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Large
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61.1
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62.3
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96.0
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Medium
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69.4
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102.1
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121.1
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Small
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61.1
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59.7
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113.1
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Legend for Figures 3-5
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