The After-Tax Performance of Mutual Funds: Why It's Important

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The After-Tax Performance of Mutual Funds: Why It's Important
by James D. Peterson, Ph.D., Vice President, Mutual Fund Research, Schwab Center for Financial Research and
Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
September 2, 2003

Everyone wants their mutual funds to provide high returns, whether you hold the funds in non-taxable or taxable accounts. However, if the funds are held in taxable accounts, you'll want the highest possible returns after taxes—after all, it's not what you make but what you keep that matters.

If you're trying to choose an appropriate fund for a taxable account, you need to know which factors influence a mutual fund's after-tax performance. The Schwab Center for Investment Research (SCIR) analyzed after-tax returns of a large sample of domestic equity funds over the time period of 1981-2001 and found that:

Investors should look at funds with good past performance, low expenses and high historical tax efficiency.
Investors should try to avoid investing in funds that have recently experienced large net redemptions.
While risk, market capitalization and investment style (growth vs. value) do affect a fund's performance, it's difficult to forecast the investment category likely to be in favor. Thus, investors should simply diversify across categories as best they can.

The study
From 1981 through 2001, high-tax-bracket¹ investors lost an annual average of 2.36% of the value of their domestic equity mutual funds to taxes.² Two percentage points may not seem like much, but it adds up over time. The table below shows how, due to the power of compound growth, even a small amount of return lost to taxes can have a big impact on the future value of your savings.

Taxes can take a bite out of your nest egg

Pre-tax return	After-tax return	Return lost to taxes*	Initial investment	Value in 20 years
10%	10%	0%	$10,000	$67,275
10%	9%	0.9%	$10,000	$56,044
10%	8%	1.8%	$10,000	$46,610
10%	7%	2.7%	$10,000	$38,697

*Compounded on an annual basis.
Source: Schwab Center for Investment Research. This is a hypothetical investment and does not represent a specific investment product.

Despite the effect of taxes on mutual fund returns, most published research focuses on pre-tax performance. To fill this gap, SCIR analyzed after-tax returns on 4,427 domestic equity funds from 1981 to 2001 to identify which fund characteristics readily available to individual investors were useful for explaining subsequent three-year, after-tax performance differences among funds over this time period.

Why focus on after-tax returns?
When purchasing funds for a taxable account, it's good to pay attention to all factors affecting after-tax returns and not just to tax efficiency. The table below highlights why.

*Compounded on an annual basis.

Fund C clearly is the most tax-efficient fund, with a return lost to taxes of less than 1%. However, Fund B shows the higher percentage after-tax return—and the objective is to take home the most money after Uncle Sam takes his cut.

Which variables are the most important?
We discovered that investors seeking funds with low expenses, good past performance and high past tax-efficiency are looking for the right things. These factors—along with risk, market capitalization, investment style and the recent occurrence of large net redemptions—were important determinants of after-tax returns.

The 2003 tax cut
As a result of the Jobs and Growth Tax Relief Reconciliation Act of 2003, "qualified" dividends and long-term capital gains are now taxed at 15% (or 5%) through 2008. In addition, the top ordinary tax bracket has been lowered to 35% through 2010.

What are the implications of the new tax law change for investors?

Generally speaking, overall tax liability and, consequently, return lost to taxes should be lower on an absolute basis for most investors in light of the new tax law. But they can still be significant. (Remember, without further action by Congress, the new, lower rates on dividends and long-term capital gains are set to expire after 2008 and the lower ordinary brackets are set to expire after 2010.)
If market returns over the next 20 years turn out lower than what investors enjoyed on average during the 1980s and 1990s, then taxes might well be of even greater concern. For example, average high-single-digit return expectations for stocks would mean that any return lost to taxes would be felt to a greater degree. In short, paying attention to taxes is as important as it ever was.

What it means for you
Our findings underscore the benefits of being a tax-aware investor. While you shouldn't let the tax tail wag the investment dog, the ultimate effect of taxes on your portfolio can be substantial, even after the 2003 Tax Act.

We recommend diversifying across investment categories (large-cap/small-cap and value/growth) and focusing on funds with good historical pre-tax performance and low expenses. In addition, investors should focus on funds with high past tax efficiency (i.e., a track record of low return lost to taxes) that have not recently experienced large net redemptions.

In a post-bear market environment, return lost to taxes may be temporarily distorted because of unrealized losses and realized capital loss carryovers. During these times, investors may want to look at the fund's prospectus to help determine if the fund uses a tax-efficient investment strategy. In more typical up-market environments, funds that follow tax-efficient strategies should provide higher after-tax returns, holding other things constant.

Before purchasing a fund, however, check with the fund company to learn if the fund expects to distribute a capital gain. If so, you'd have to pay taxes on your share of the distribution, whether or not you ultimately experience gains or losses on your investment in the fund. For this reason, you may want to avoid buying a fund that's about to distribute a capital gain.

And, if you're one of those investors who has a large amount of money in taxable accounts, you might want to consider separately managed accounts or other investment vehicles that provide more direct control over the realization of capital gains.

Finally, investors with both taxable and tax-deferred accounts should pay attention to the efficient placement of their investments between both account types.

1. For years prior to 1993, we use the ordinary income tax rates for "high-tax individuals" as determined by Dickson, Joel M. and John B. Shoven, 1993, "Ranking Mutual Funds on an After-Tax Basis," National Bureau of Economic Research Working Paper: 4393. Post-1992, the ordinary income tax rate is the maximum federal marginal tax rate.

2. This calculation includes taxes on distributions from the fund only; it does not include any taxes associated with selling fund shares.

Past performance is no guarantee of future results.

Principal value and investment returns will fluctuate with changes in market conditions so that an investor's shares when redeemed may be worth more or less than their original cost.

Small-cap funds are subject to greater volatility than those in other asset categories.

Prospectuses containing more complete information, including management fees, charges and expenses, are available from Schwab by calling 1-800-435-4000. Please read the prospectus carefully before investing or sending money.

The Schwab Center for Investment Research is a division of Charles Schwab & Co., Inc.

The information provided in this report is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The types of securities mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Data contained here are obtained from what are considered reliable sources; however, their accuracy, completeness or reliability cannot be guaranteed. Past performance cannot guarantee future results.

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