Chapter 13

On Taxes

The Message of the Parallax

Often, a small change in vantage point can engender a large change in perception. So it is with the parallax, exemplified by the angle created by the 2½-inch distance between our eyes, which enables us to visualize objects in three dimensions. As I discussed in Chapter 3, mutual fund investment has four dimensions: return, risk, cost, and time. It is conventional to consider investments on the basis of return and risk, but I believe that adding cost as a third dimension provides a far better understanding of investment returns generally, and mutual fund returns in particular. Thus, I apply the principle of the parallax to mutual funds.

The impact of cost is greatly magnified when we consider not only the substantial operating and transaction costs of mutual funds, but the cost of taxes as well. The profound impact of taxes on fund returns is a subject too long ignored. Fund managers may feel that they can afford to ignore it, but fund owners ignore it at their peril. With an estimated $700 billion of capital gains currently on the books in mutual fund portfolios, it is high time for the subject of taxes to receive the exposure it deserves. To be sure, an investor’s goal is not simply to minimize the tax burden, but rather to achieve the highest possible net returns. Paradoxically, however, a focus on minimizing taxes seems not only not to diminish, but to enhance pretax returns.

Given the remarkable increase in potential tax liability that has come hand in hand with the 16-year bull market, it’s especially timely to acknowledge taxes as a major aspect of the cost of investing in mutual fund shares. Alas, it is too late to discuss the taxes that fund investors paid by April 15, 1998, on the $180 billion of capital gains that the industry realized during 1997. But although taxes paid on those gains are water over the dam, the issue has hardly vanished. Tens of billions of gains realized and distributed in 1998 must be reported on tax returns for 1998, and tax on them paid by April 15, 1999.

At this point, a caution: The huge $700 billion estimated unrealized tax liability is a very volatile number; it is highly sensitive to changes in the level of the stock market. In a market decline, unrealized gains come right off the top. A 25 percent market decline, for example, would eliminate the industry’s entire potential net tax liability, even as a 25 percent market increase would double it. Please bear this high leverage in mind as you consider the impact of taxes on the returns you earn on your fund investments. Also, remember that the substantial gains already realized but not yet distributed will be distributed and will become taxable to shareholders, even if the industry’s unrealized gains were entirely erased by a market decline. Almost no matter what the market does, substantial capital gains will be distributed to fund investors for many years, for the large amount of unrealized gains on fund books is unlikely to be washed entirely away.

It is ironic that the mutual fund industry’s high turnover policies have exacerbated the tax issue. As managers turn over their portfolios in an ongoing attempt to beat the market—all the while failing to do so—this activity places a further burden on the backs of taxable shareholders: a cost increase that substantially magnifies the existing shortfall to the market reflected in the reported (pretax) returns of the overwhelming majority of mutual funds.

Earlier, I noted that during the 16-year bull market through June 1998, the average equity mutual fund provided a return of 16.5 percent versus 18.9 percent for the total stock market. This shortfall of 2.4 percentage points per year—engendered importantly by annual costs of about 2 percent—may not look excessive when subtracted from a market providing an annualized return of nearly 20 percent. But, over time, it would consume fully one-fourth of a 10 percent return, to say nothing of confiscating one-half of a 5 percent return.

Consider for a moment what is called “alpha.” It is a vital measure of a fund’s return relative to the stock market, adjusted to reflect the relative risk assumed by the fund. The statistics are quite clear. (Morningstar Mutual Funds is the best-recognized source.) They show that the average mutual fund has provided an alpha—a risk-adjusted return relative to the market—of minus 1.9 percent per year (“negative alpha,” as it is known) during the past decade. In other words, the annual return earned by fund investors was almost 2 percentage points less than they might have expected. This number roughly equals the industry’s annual costs. It is no accident that alpha is normally quite similar to fund total operating and transaction costs. But it doesn’t take into account the hidden cost of taxes.

TEN YEARS LATER

Taxes

It was easy to prophesy, as I wrote in the 1999 edition, that “almost no matter what the market does, substantial capital gains will be distributed to fund investors for many years.” And so it was to be. Since 1998, equity mutual funds have distributed nearly $1.5 trillion of realized capital gains to their shareholders.

Despite the fact that these funds earned little or no capital appreciation during this period, they paid out these gains to their shareholders, year after year, ranging from a high of $380 billion in 2007 to a low of $7.7 billion in 2003. Even the losses the funds incurred in two major bear markets—in 2000 to 2002 and in 2007 to 2009—have been insufficient to stop the flow of these distributions, and the attendant tax liabilities that burden their taxable investors. (About one-half of equity fund assets are held by taxable investors; the other half are held in tax-deferred retirement plans.)

Taxes—The Industry’s Black Sheep

The tax issue is the black sheep of the mutual fund industry. Like a cousin who can’t get her life together or an uncle who drinks too much, taxes are kept out of sight and out of mind. But investors cannot afford to turn a blind eye to this issue. For it is the fund shareholder who pays the taxes on a mutual fund’s income dividends and on any capital gains distributions generated by the fund’s constant staccato of portfolio sales, and—at least in the recent bounteous bull market—by the realization of enormous taxable capital gains. The dichotomy is that a portfolio manager’s performance is measured and applauded on the basis of pretax return—never mind that the Internal Revenue Service confiscates a healthy share of it. Few portfolio managers spend their time agonizing over the tax consequences of their decisions.

Ever since the creation of the first mutual fund in 1924, the industry has essentially ignored the tax issue. Indeed, for decades, funds were sold as much on the basis of “looking for more income” as on the basis of total return. (In the 1940s and early 1950s, stock yields averaged 8 percent and bond yields averaged 2½ percent. Imagine!) The industry often sloughed off the difference between income dividends and capital gains distributions. They were added together to arrive at a “total distribution yield,” a practice not legally permitted since 1950. In recent years, as tax-deferred IRA accounts and 401(k) corporate retirement plans have come to the fore, tax considerations have gotten even less attention. In fact, investors in tax-deferred retirement plans, which as a group hold 40 percent of the assets of equity funds, are now the driving force in industry growth. Investors in these accounts need burden neither their minds nor their checkbooks with tax issues.

But the owners of the other 60 percent of fund assets do not have the luxury of ignoring tax considerations. Each year, they must pay taxes on the fund distributions they receive. Yet mutual funds do not provide adequate disclosure about the tax implications of their investment strategies, portfolio turnover expectations, and gain realization policies. Look under the “Dividends, Capital Gains, and Taxes” heading in a typical fund prospectus, and you’ll find something like: “The fund distributes annually substantially all of its net income after expenses and any capital gains realized from the sale of securities. Dividends and short-term gains are taxable to you as ordinary income; distributions of long-term capital gains are taxable to you as long-term capital gains.” That is proper disclosure as far as it goes. But it doesn’t go nearly far enough.

Portfolio managers, fund sponsors, and distributors know that funds don’t pay much, if any, attention to tax concerns. Rather than ignore this important fact, they ought to call it to the attention of investors. Here’s my try at a much-needed prospectus disclosure:

The fund is managed without regard to tax considerations, and given its expected rate of portfolio turnover, is likely to realize and distribute a high portion of its capital return in the form of capital gains that are taxable annually, a substantial portion of which are likely to be realized in the form of short-term gains subject to full income tax rates. (Some funds might be entitled to modify the last phrase.)

There would seem to be only two reasons that the disclosure of that known fact does not find its way into today’s prospectuses: inadvertence, or some sense that it would hurt the fund’s marketing effort by encouraging investors to focus on the negative impact of excessive taxes on their total returns. Whatever the reason, I believe that the sentence quoted should be included as a prominent part—if not the opening sentence—of the disclosure of fund tax considerations in the prospectus. Full disclosure must be the order of the day.

TEN YEARS LATER

The Industry’s Black Sheep

As far as I know, no mutual fund has yet taken my advice, and made the honest disclosure about taxes that I recommended in the previous edition.

The Remarkable Value of Tax Deferral

The serious problem created by the relatively prompt realization of capital gains by funds is that investors must pay taxes on them almost immediately. Yet the truly enormous value of deferring capital gains taxes seems almost universally ignored. To put it simply: A tax that is deferred is the functional equivalent of an interest-free loan from the U.S. Treasury Department, with a maturity equal to the number of years of deferral. You will probably owe the tax someday, but you don’t have to pay it until then.^z Just imagine the value of a 10-year interest-free loan, or even a 25-year loan. Better still, calculate it. A $1.00 loan repayment deferred for 10 years has a present value of 47 cents; with a 25-year loan, that figure is just 15 cents! But mutual fund history suggests that as few as 5 percent of all fund holdings can be expected to be held for 10 years, and thus gain that 53-cent bonus on each dollar deferred for a decade, to say nothing of the bonus of 85 cents per dollar over a quarter century.

As of late 1998, mutual funds were carrying an estimated appreciation of a cool $700 billion (25 percent of equity fund assets), representing a potential liability to their taxable shareholders of some $100 billion. As much as $200 billion of net gains have been realized during 1998, and distributed at year-end. The remaining $500 billion of those gains have not yet been realized, but, assuming that market prices hold constant, will ultimately be realized and subject to taxes. The mammoth distribution of gains realized in 1998 will likely constitute about $150 billion in long-term gains and $50 billion in short-term gains. Perhaps $80 billion of the $200 billion will be received by investors in tax-deferred retirement programs. The $120 billion received by taxable investors for 1998 gains, then, will carry an estimated tax liability of more than $30 billion. One can only hope that they are ready to pay it.

External circumstances could exacerbate the situation in 1999. If a market decline were to cause net liquidations of fund shares, it would increase per-share distributions. Conversely, a rising market might bring in new money at ascending prices, which would dilute per-share distributions. That is why mutual fund unrealized gains, relative to the rise in stock prices, have been small so far. Curiously, investors don’t seem to object to paying $10 per share for a fund with a potential tax liability for, say, $2.50 in unrealized capital gains in its portfolio. In a down market, when share prices tumble, it is possible, if not likely, that relatively new fund investors, with unrealized losses, would nonetheless receive substantial taxable capital gains distributions. (Fund accounting practices give rise to strange outcomes.) Forewarned is forearmed.

With all this background, let’s look at the impact of taxes in a longer-term context. On the income distribution side, perversely enough, the tax impact is, in a sense, beneficial. In late 1998, equity mutual funds were earning gross income—before expenses—at a rate of about 1.9 percent. (Their equity holdings yielded about 1.2 percent; their 10 percent position in bonds and cash reserves yielded about 7 percent.) But annual fund expenses averaged 1.5 percent, so equity fund investors were receiving a puny yield of less than 0.5 percent on which to pay taxes. Expenses were consuming some 75 percent of fund income. In the paradoxical world of mutual funds, the higher the expense ratio, the more tax-efficient the income component of total return. But there is such a thing as paying too much for tax efficiency, as reflected in that perverse example. In a sense, mutual fund expenses represent a tax rate of 75 percent on gross income, deducted before the regular taxes are even paid. It is Alice in Wonderland writ large.

Alpha Takes Another Hit . . . from Taxes

The impact of taxes on the capital component is another story altogether. Here, tax-inefficient is the operative term for mutual funds. The tax blessing, as it were, in the income component of return is overwhelmed by the tax bane on the far larger capital component. A simple example: During the past 15 years, the average equity fund enjoyed an average annual return of 14 percent. Let’s assume 3 percent of the return came from income and 11 percent from capital, of which 8 percent was realized. Let’s further assume that 30 percent of the capital gain was realized on a short-term basis. (These assumptions closely parallel actual industry experience.) On the income side, the tax bite, assuming a 33 percent average rate, would reduce return by 1 percent. On the capital side, with a 33 percent rate on short-term gains taxable as income, and a 25 percent tax rate on long-term gains, taxes would claim 2.2 percent of return. In all, taxes would have reduced the reported returns of the average equity fund from 14 percent to 10.8 percent, while leaving risk unchanged.¹

The fact is that taxes have a hugely negative impact on relative returns. An outstanding article by Robert H. Jeffrey and Robert D. Arnott in the Journal of Portfolio Management, “Is Your Alpha Big Enough to Cover Its Taxes?,”² concludes that it is not. I’ll add: No, your alpha is being eaten alive by taxes. That situation is made somewhat more dire by the fact that equity funds, as we’ve seen, largely because of their investment costs, already have had a negative alpha of -1.9 percent annually over the past 10 years. On an after-tax basis, that negative alpha nearly triples to -5.1 percent. Professional investors all know that successful investing is a tough game. But fund costs and taxes, some paid unnecessarily, make it even tougher. Even if some individual investors are aware how much tougher the game is when fund expenses and taxes are deducted from the manager’s returns, all fund investors should be told the facts—and the figures—with candor. That 5.1 percent slice confiscated more than one-fourth of the stock market’s return in the past decade.

Fund Portfolio Turnover Soars

It’s important to recognize that what’s happening here is largely the product of the inordinately high portfolio turnover rates of mutual funds. Twenty-five years ago, fund portfolio turnover averaged 30 percent annually; today, it averages nearly 90 percent. Individual investors may hold stocks for decades, and families may hold them for generations, but mutual funds are rushing to buy and sell their stocks with seemingly carefree abandon based on transitory changes in prices and without concern for tax consequences. This behavior sharply reduces the returns generated for their taxable owners.

Further, some fund managers are so trigger-happy that many of the gains are short-term in nature (less than one year) and are taxed at ordinary income rates. In recent years, some 30 percent of fund gains fell into this category, but with the end of the long-standing limitations on “short-short” gains under the so-called Taxpayer Relief Act of 1997, this figure could well increase. Now, portfolio managers can feel free to realize an unlimited percentage of the fund’s income in the form of gains realized in less than 30 days. For mutual fund shareholders, the economic value created by this change in the law is dubious in the extreme.

It is highly unlikely that fund turnover will slow so greatly that it will mitigate the gain realization issue. Reducing a fund’s turnover from 150 percent to 100 percent simply doesn’t matter. Substantially all gains are realized fairly quickly. Authoritative studies suggest that turnover rates would have to be reduced to 20 percent or less to engender a material lessening of the tax burden. But any turnover, by forcing shareholders to give up the value of that implied interest-free loan, has a negative impact on the net returns enjoyed by investors.

What happens when the basic strategy of a fund calls for limited turnover? Something very good for fund investors. The amount of tax due falls, and the after-tax return rises accordingly. It is that simple. As taxes are deferred, returns rise significantly with each additional year that an investor elects to hold fund shares. And through tax elimination—for example, if an investor’s heirs receive the shares with a stepped-up cost basis at the time of the investor’s death—after-tax returns leap ever higher.

Fund Manager Turnover Doesn’t Help

Even if, as a policy matter, good intentions exist to reduce turnover, it soars—and substantial gains are realized—when a new portfolio manager is brought in to manage a fund. This event happens with increasing frequency in this era of manager turnover. Superstar managers may be lured away by huge stipends, or entrepreneurial instincts, or the fact that the large asset size of the funds they manage has impeded their ability to deliver outstanding returns. But whatever the case, fund portfolio managers currently have an average tenure of only five years.

To say that these are critical issues for taxable mutual fund investors would be a powerful understatement. As James P. Garland, president of the Jeffrey Company, has observed, “Taxable investing is a loser’s game. Those who lose the least—to taxes and fees—stand to win the most when the game’s all over.”³ Garland compared the hypothetical after-tax returns of an investor in a typical fund and a tax-managed index fund over the 25-year period from 1971 to 1995. During this period, the Standard & Poor’s 500 Index earned a compound rate of return of 12.0 percent (before taxes). After expenses and taxes, the average mutual fund compounded at 8.0 percent, and the tax-managed fund compounded at 10.2 percent. (See Figure 13.1.)

FIGURE 13.1 Cost—The Third Dimension: Fund Expenses Plus Taxes, $1,000,000 Investment, 25-Year Returns (1971-1995)—Market Return 12.0 Percent

After relinquishing 16 percent of final fund total returns to the fund manager and 44 percent to the government, a fund investor retained but 40 percent of the theoretical tax-free market return. For a tax-managed index fund, 6 percent of the final value accrued to the manager and 27 percent to the government; the investor retained 67 percent. For an investor who began the period with an investment of $1 million, the net result was a final capital pool of $11.3 million in a low-cost tax-managed fund, compared to $6.8 million for an investor in a typical mutual fund.

With decidedly mixed emotions, I tell you that the Garland methodology seriously overstated the net return of the typical fund. It assumed a fund expense ratio of 1 percent and ignored fund portfolio transaction costs. As I have noted, however, all-in costs incurred by funds today average 2 percent or more. The methodology also assumed that all capital gains were realized on a long-term basis (28 percent tax) when, in fact, perhaps one-third of fund gains were actually taxable at a (then) short-term rate of 36 percent.^aa The study also moderately understated the results of the tax-managed index fund. It assumed a 0.3 percent expense ratio when 0.2 percent would have been more realistic. But, even giving the benefit of a very large doubt to the typical fund, the impact of taxes and expenses on mutual fund returns is astonishing.

TEN YEARS LATER

Tax Rates

In 2003, the maximum federal tax rate on long-term capital gains was reduced from 20 percent to 15 percent, and the maximum tax on short-term capital gains and ordinary income was reduced from nearly 40 percent to 35 percent. It seems highly likely that both tax rates will be increased for 2010, to levels likely at or even above their previous levels. State and local taxes, of course, make the tax burden on investors even larger.

A Good Solution: The Index Fund

At this point, you are probably thinking that you should forget about mutual funds, at least for taxable accounts, or that there must be a better way to achieve the valuable diversification that mutual funds clearly provide. Well, there is a better way. You can avoid suffering the negative consequences of both high costs and excessive taxes, and come as close to achieving a positive alpha as the law of the financial markets allows. A relative handful of funds operate at a minimal cost and with a minimal tax burden. Most are broadly based market index funds (for example, those based on the Standard & Poor’s 500 Index) or index funds replicating the entire stock market (the Wilshire 5000 Equity Index). And they are working well (especially the Wilshire index) because significant changes to their composition rarely take place.

Let’s begin with a baseline: the after-tax return of the S&P 500 Index. We’ll deduct income tax from the dividends, assume no capital gain realization, and defer all capital gains taxes. With a pretax return of 17.2 percent over the 15 years from June 1983 to June 1998, and assuming an estimated tax impact of -1.5 percent (largely because of income taxes), the after-tax return turns out to be 15.7 percent, 91 percent of its pretax return.

Now let’s turn to the real world and calculate the comparable figures. For an average mutual fund, the 15-year pretax return was 13.6 percent and taxes were 2.8 percent, producing an after-tax return of 10.8 percent—a flow-through of 79 percent. For comparison, Table 13.1 shows the record of the Vanguard 500 Index Fund. Its pretax return was 16.9 percent, of which taxes consumed 1.9 percent, leaving a net return of 15.0 percent. As a result, the Vanguard 500 Index Fund’s rank rises from the 94th to the 97th percentile. The former advantage is shaped largely by the high costs incurred by the typical actively managed mutual fund; the latter, by the heavy tax burden engendered in this typically high-turnover industry.

TABLE 13.1 S&P 500 Index Fund and Average Mutual Fund

During this 15-year period—admittedly, a good time frame for the giant-cap stocks that dominate the index—the focus on low costs helped place the index fund near the top of the mutual fund industry. Its focus on tax minimization took it even higher, bringing it nearly halfway toward being number one. Outpacing 97 percent of all equity funds on an after-tax basis over a decade and a half hardly seems a shabby accomplishment for a passively managed fund lacking even the putative advantage of a skilled portfolio manager.

Once again, these numbers overstate to some degree the returns of regular mutual funds, because the underperforming mutual funds drop out of the race and thus out of the return calculations. And the powerful impact that this survivorship bias has on reported industry returns is no trivial matter, as I’ve shown in Chapter 5. If the return of the average mutual fund, displayed in Table 13.1, were to be corrected for this bias, then the fund underperformance would have been even more dramatic.

In fairness, however, the index fund returns are also lower than the returns of the index itself, because they are reduced by portfolio transaction and operating costs. No matter how modest, these costs exist in the real world. From 1983 to 1998, for example, the Vanguard 500 Index Fund’s returns of 16.9 percent before taxes and 15.0 percent after taxes compared to 17.2 percent and 15.7 percent respectively for the index itself.

TEN YEARS LATER

A Good Solution

Despite the harsh market conditions that prevailed during most of the 15-year period ending in mid-2009, the index fund produced a similar, albeit arguably larger, advantage than that which it achieved in the 15 years ended in mid-1998. While the index fund earned an annual return of 6.7 percent before taxes, the average equity fund earned a return (adjusted for sales loads and survivor bias) of just 5.4 percent, a 1.3 percentage point shortfall. After taxes, just as in the earlier comparison, the managed fund shortfall got even larger, rising by 1.1 percentage points to a total of 2.4 percent, compared to the 4.2 percent shortfall in the earlier tabulation. (Put another way, the total shortfall, after taxes, was equal to 39 percent of the index fund’s return in the recent period, even worse than the 28 percent shortfall in the previous period.)

Results Confirmed

The results of this analysis have been confirmed by other independent studies. The most rigorous study was prepared by Joel M. Dickson and John B. Shoven of Stanford University. They found that during the 10-year period ending in 1992, an actual mutual fund modeled on the S&P 500 Index provided an annual after-tax return of 13.4 percent compared to 10.7 percent for the median equity mutual fund. That advantage of 2.7 percentage points annually moved the index fund up from the 79th percentile to the 86th percentile, leaping over 10 of the 31 funds in their 147-fund sample that had provided higher pretax returns.⁴

There is a high degree of certainty that the low-cost advantage of indexing will persist. But there may be a lower level of certainty that the deferral of gain realization will persist. First, index funds, by virtue of their low turnover, should build up their unrealized gains over time. At some point down the road, a portion of those gains may be realized. Second, despite the intention of an index fund to avoid realization, it could be susceptible to a run of shareholder redemptions that could force it to liquidate highly appreciated portfolio holdings. Nonetheless, given the huge value of tax deferral for a long period, and its considerable value even for a limited period, it is difficult to visualize a circumstance under which the potential tax advantage offered by index funds, relative to traditional actively managed funds, will not persist.

A Better Solution: The Tax-Managed Fund

New funds are finally being developed that should provide an even better solution than the regular index fund to the tax problem faced by mutual fund shareholders. In 1994, one fund group, interested in improving the tax efficiency of conventional index funds, developed the industry’s first series of low-cost tax-managed funds. The most popular form is based on:

• Using a market index strategy, but emphasizing growth stocks and holding lower-yielding equities, in order to minimize the tax burden on income.

• Realizing, to the maximum possible extent, losses on the sale of portfolio holdings that have declined (a practice known as “harvesting losses”), and thereby offsetting realized gains when they occur.

• Replacing the holdings sold at a loss after 30 days. (During the interim, their absence from the portfolio could engender a small lack of precision in matching the index.)

• Limiting its shareholder base to investors with a long-term focus by charging a penalty—a transaction fee, payable to the fund and its remaining shareholders—if shares are redeemed within five years of purchase. Such a penalty is designed to minimize the possibility of abrupt share redemptions.

• Maintaining the same rock-bottom costs that characterize the lowest-cost index funds.

Based on the relatively short experience of these tax-managed funds, this approach seems to be working well. Thanks to the penalty provisions, redemptions are a tiny fraction of industry norms; speculative market-timing short-term investors have been conspicuous by their absence; and no capital gains have yet been realized. What is more, they have provided excellent returns relative to comparable actively managed funds.

More recently, others in the industry have begun to respond; more than a score of other purportedly tax-managed funds have been formed. But few follow an index strategy, and few have taken tangible measures, such as penalty fees, to limit redemptions. The funds’ expense ratios are no lower than the norms for other managed funds, relinquishing another key advantage. Overall, except for their intention to lean against the wind to avoid excessive turnover, their investment objectives are conventional. Further, it is not clear what will happen when they experience the inevitable portfolio manager turnover. Together, these potential negatives are apt to make it difficult to reduce materially either the tax bite or the bite that operating expense ratios take out of alpha.

When properly structured, however, tax-managed funds seem destined to become a strong force in the mutual fund field—made even stronger, I believe, by the reduction of taxes in the Taxpayer Relief Act of 1997. Under previous law, the 28 percent capital gains rate was 12 percentage points below the 40 percent maximum marginal income tax rate. The new rate is 20 percent—that is, 20 percentage points below the 40 percent income tax rate. This change raises the tax discount on long-term gains from 12 percentage points to 20 percentage points—an increase of fully 1.7 times and a further enhancement to the value of long-term deferral. But high-turnover funds—holding stocks for less than a year on average—continue to subject shareholders to full income tax rates on their short-term gains, and sacrifice the considerable value of tax deferral on their long-term gains.

A New Idea, Sixty Years Old

With all of the high-priced creative and imaginative talent in the mutual fund industry, why hasn’t someone, somewhere, dreamed up a still better way to enhance after-tax mutual fund returns? Surely the opportunities abound. Let me describe one idea. Start with a fund that simply buys a large sampling of high-quality blue-chip growth stocks, and holds them unless fundamental circumstances change radically. Where do we find a budding Warren Buffett to manage it? Honestly, I don’t know. As an alternative, how about a fund that buys, say, the 50 largest stocks in the Standard & Poor’s Growth Index universe? (That’s 80 percent of the capitalization of the growth universe and 30 percent of the entire stock market.) The fund holds these 50 stocks, without rebalancing as prices change. If there is a merger, keep the merged company. If a company is bought for cash, reinvest the proceeds in the next largest growth company or in the fund’s other holdings (the choice probably won’t matter).

No manager would be needed, so the fund would incur only bare-bones operating costs, perhaps totaling an expense ratio of 20 basis points. Minimize exposure to shareholder redemptions by imposing stiff redemption fees and/or strong limitations on daily liquidity (perhaps open the fund for redemption only on the last day of each quarter). Finally, when shares are redeemed, don’t sell stocks to meet the redemption. Pay the investor in shares of the highly marketable securities in the portfolio (redemption in kind). Explain in advance that this is what you will do. Those investors will realize the same tax that they otherwise would on any gains, and the fund’s tax integrity will be preserved. These procedures will make the fund unattractive to quick-triggered opportunists—a good outcome for shareholders. And, over time, these sound policies will make it commensurately easier to attract serious long-term investors, who will otherwise become an endangered species.

The potential rewards are huge. In a stock market that averages a 10 percent pretax return, the average fund (assuming a 2 percent expense ratio) might provide a pretax return of 8 percent and an after-tax return of 6.5 percent. A low-cost, buy -and-hold fund with a 10 percent gross return and expenses of 0.2 percent should achieve a net return of 9.8 percent before taxes and 9 percent after taxes. This is a conservative hypothesis, for the hypothetical after-tax spread of 2.5 percent is well below the actual after-tax shortfall of 4.3 percent that actually existed between active funds and the S&P 500 Index during the past 15 years.

For long-term investors, these numbers would be little short of dynamite. After 25 years and net of all taxes, $100,000 invested at the outset would have grown to $483,000 in the actively managed fund. But the buy-and-hold fund would have reached $862,000, or almost double that amount. It is surely fair to conclude that both fund expenses and taxes matter—in large magnitude.

The potential risks are small. Here are the mathematics: The 30 percent of the entire investment universe currently represented by the 50 largest growth stocks would have to underperform the remaining 70 percent of the market by more than 3.0 percentage points per year for 25 years—at which point, the choice between the two funds would be indifferent. The powerful forces of efficient financial markets would likely repel any such challenge. History reflects the fact that growth stocks and value stocks have provided virtually identical returns over the past six decades (see Chapter 10). Such a defeat for our hypothetical fund could be accomplished, over the long term, only against all odds. The surprising, if simple, fact is that broad diversification makes it just as difficult to achieve significant underperformance relative to the market as to achieve significant overperformance. In short, the risk-return equation appears highly favorable, thanks simply to the minimization of the fiscal drag of costs—operating expenses and tax penalties alike. That’s the three-dimensional view from this pair of eyes.

A look at history might help to evaluate the risk that growth stocks, even when purchased at notably high valuations, will underperform the market over the long run. Jeremy J. Siegel helped to answer the question with his study of the performance of the famous Nifty Fifty growth stocks of the go-go era of 1965 to 1972. In an article in the Journal of Portfolio Management, Professor Siegel showed that a frozen portfolio, equally weighted in those 50 highly valued stocks and purchased at the start of 1971 (near the peak of the market) marginally outperformed the stock market as a whole over the subsequent 25 years.⁵ Some of the 50 did well: Philip Morris was the champion, up 21 percent per year, with McDonald’s (+18 percent), Coca-Cola, and Disney (each +16 percent) in close pursuit. Some did poorly: MGIC Investment finished last on the list, losing more than 4.6 percent per year; Emery Air Freight (-1 percent) did nearly that badly; and Polaroid (+2 percent) and Xerox (+5 percent) also ranked near the bottom.

On a pretax basis, the Nifty Fifty portfolio earned an average annual return of 12.4 percent, an advantage of just 0.7 percentage points over the stock market return of 11.7 percent. But on an after-tax basis, this relative advantage grew significantly: The Nifty Fifty portfolio advantage increased to fully 2 percentage points per year (9.8 percent versus 7.8 percent). These long-term past returns, earned on a static portfolio oriented to growth, in retrospect bought at a high price, surely validate this concept. At the end of the period, an initial investment of $10,000 in the Nifty Fifty portfolio, after the deduction of taxes, was worth $98,000 versus $63,000 for the stock market as a whole. The average mutual fund, of course, trailed far behind the market during that period.

TEN YEARS LATER

The Tax-Managed Fund and a New Idea

My prediction that “tax-managed funds seem destined to become a strong force in the mutual fund field” proved wide of the mark. Only 26 tax-managed U.S. equity funds exist today, with some performing admirably and others performing badly. Perhaps the tax cuts of the early 2000s are partly responsible for my failed prediction; perhaps rising tax rates will bring taxes back into focus. However, most equity fund portfolios now have substantial unrealized losses, and ultimately those losses will be used to offset any gains on portfolio holdings in the future. As a result, capital gains distributions should become a far less significant factor in the years ahead.

And as for that “new idea”? Well, it went nowhere. A pure buy-and-hold fund with a portfolio of 50 growth stocks—a Nifty Fifty portfolio—has yet to be offered to the investing public. It remains to be seen whether such a portfolio would be an attractive option relative to a growth index fund, a tax-managed aggressive growth fund, or for that matter a simple tax-managed S&P 500 Index fund.

Nothing New under the Sun

There is, Ecclesiastes tells us, nothing new under the sun. That ancient maxim, in a sense, applies to this “new idea.” A tiny coterie of mutual fund historians might still remember a similar fund formed in 1938, which gave early credentials to the buy-and-hold idea. Structured as a fixed trust, Founders Mutual Fund picked an equal-weighted portfolio of 36 of the blue-chip stocks of the day, and held them until 1983, when the fund abandoned the strategy. At the end of that 45 - year period, Founders held the same 36 stocks it had owned at the outset. Among them were IBM, Procter & Gamble, DuPont, Union Pacific, and Eastman Kodak—not only durable (by definition), but successful enterprises.

Individual Stocks versus Mutual Funds

In recent years, the flight of investor capital out of individual stocks and into mutual fund shares has reached landslide proportions. For investors in tax-deferred IRAs and corporate retirement plans, that’s a good thing in many ways; while their costs are often far too high, funds provide individual investors with far greater diversification and more professional investment oversight than they otherwise might have enjoyed. For taxable investors, however, the benefits of mutual funds are eroded considerably by their realization of capital gains prematurely. When these gains are distributed—as they must be, under federal law—fund shareholders lose the remarkable advantage of tax-free compounding, and often receive gains realized in holding periods so short that the gains are subject to taxes, not at the top 20 percent rate on long-term gains, but at the rate of up to 40 percent applied to gains realized by the fund on portfolio securities held for 12 months or less.

In the real world of capitalism and competition, one would have expected the industry to have provided, long ago, a wide array of mutual funds with objectives and strategies that would meet the needs of taxable investors. That seemingly inevitable development, however, has yet to gather momentum. I believe the reasons lie in the industry’s complacency about investors’ lack of awareness of the impact of taxes (perhaps itself inevitable, given the magnificent stock market environment), as well as its hesitancy to offer new funds with objectives and strategies that, at least to some degree, resemble the passive investment, mini mum turnover, high quality, and low costs of index funds. As much as it would serve the interests of investors, that concession would hardly serve the financial interests of most management companies. There has been little innovation (even the new “old” fund I’ve described in this chapter has yet to be offered to investors), and they are left with few satisfactory choices.

Still, investors—or at least substantial investors who have the means to diversify on their own—are not without recourse. They can simply abandon mutual funds and buy stocks directly. To some degree, such a strategy may increase their risk, although much of the risk involved in stock selection can be diversified away by owning, say, 15 to 20 stocks of blue-chip growth companies in unrelated lines of business. But the strategy surely ought to increase returns, for the tax burden of fund investing (added to the ever increasing cost of fund ownership) can be remarkably reduced. By offsetting the added risk with more-than-commensurate after-tax reward, canny investors can markedly enhance their long-term returns.

When they own individual stocks, investors are in a position to control their own gain realization. They can best determine, for their own personal and family situation, answers to questions like these:

• Should I realize gains on a short-term basis and pay a 40 percent penalty tax?

• Even if my gains are long-term, will I be able to reinvest more productively the 80 cents or more of each $1.00 of sales proceeds that I will net after taxes?

• Should I buy and hold forever, with the hope and expectation that at least one, or two or three, of my selections will become home runs, obviating the impact of my (all too likely) bad choices?

Tax control is a crucial issue for investors. If the mutual fund industry is unwilling to offer productive investment strategies to provide tax control, substantial investors will be forced to travel another route. This industry has no monopoly on managing the assets of the intelligent investor.

Prior to the change in its strategy (I couldn’t locate any record of its first five years), the Founders portfolio earned an average annual pretax return of 10.3 percent, compared to the return of 11.4 percent on the Standard & Poor’s 500 Index—a gap predictably engendered in part by the fund’s operating costs of 0.5 percent. Interestingly, its return was identical to the 10.3 percent return of Massachusetts Investors Trust (MIT, the largest equity fund throughout the entire era). I could not precisely calculate after-tax returns, but the record shows that Founders distributed only minimal gains during the period, while MIT distributed substantial gains. In short, Founders won the after-tax race.

A similar fund, Lexington Corporate Leaders Fund, formed in 1935 and invested in 30 stocks, has, impressively by fund industry standards, virtually matched the Standard & Poor’s 500 Index (15.6 percent versus 15.7 percent) over the past 22 years (the earliest comparison available using Morningstar’s database). This comparison, along with the Founders data, proves one thing and one thing only: A fund selecting a fixed initial list of large blue-chip stocks—and holding it, come what may—can give a fully competitive account of itself on an after-expense, pretax basis. By so doing, it can generate a substantial margin of after-tax advantage relative to other funds. The industry owes it to intelligent, tax-conscious investors to make such a fund available.

Tax Strategies

The objective of this chapter has been to help taxable fund investors develop intelligent investment strategies that will maximize the after-tax returns they receive from their mutual fund investments. Given the mutual fund industry’s heavy reliance on extraordinarily high portfolio turnover—which is highly tax-inefficient—the best choices are: well-structured managed funds with extremely low portfolio turnover (a universe in which there are surprisingly few fund choices); passively managed index funds focused on the entire stock market or on huge market segments such as the Standard & Poor’s 500 Index; index-oriented tax-managed funds investing in large growth stocks; and funds offering fixed portfolios, once they are again made available to investors.

But there is another key issue in investors’ tax strategy. Qualified retirement plans—401(k), 403(b), IRA—have become critically important in the accumulation of family capital. Allocation of investments between a regular taxable account and a tax-deferred account has become a decision of great moment. Common sense would seem to suggest that income-oriented assets such as bonds should be placed in the tax-deferred account, and growth-oriented assets such as stocks, which have historically provided a large share of their returns as capital gains, should be kept in the taxable account. The logic is simple: Current income is taxable at rates as high as 40 percent, whereas capital gains are subject to rates as low as 20 percent. Even more important, the realization of capital gains can be deferred indefinitely, effectively gaining an interest-free loan from the U.S. Treasury.

Through their disregard for taxable shareholders, however, mutual funds have turned that common sense on its head. John Shoven has examined the allocation of stock funds and bond funds between taxable and tax-deferred accounts.⁶ He found that, over a 30-year period, most investors would accumulate the greatest level of terminal wealth by keeping stock funds in a tax-deferred account, and holding tax-exempt municipal bond funds in a taxable account. In his analysis, he assumed that gross returns on stocks were 12 percent and gross returns on municipal bonds were 5.4 percent.

Why wouldn’t it be more rewarding to keep corporate bond funds (which, in his study, returned 7.2 percent) in the tax-deferred wrapper, and place stock funds in a taxable account? After all, as long as the stocks’ capital gains are unrealized, a stock fund won’t sacrifice very much of its 12 percent gain to the IRS, and the investor will earn higher returns from corporate bonds than from municipal bonds.

That seemingly obvious policy simply doesn’t work, mostly because the mutual fund industry pays little heed to the needs of taxable shareholders. Largely because of excessive turnover, a typical equity fund manager might transform a 12 percent pretax return into an 8.5 percent after-tax return. Through the serial distribution of long-term and even short-term gains, the manager needlessly sacrifices 30 percent of the stock market’s gain to the tax collector. Given the distribution patterns of most equity funds, Professor Shoven concludes, the long - term investor can accumulate the greatest amount of terminal wealth by keeping stock funds inside the tax-deferred account and tax-exempt municipal bond funds outside.

TABLE 13.2 After-Tax Returns of Tax-Inefficient and Tax-Efficient Stock Funds

But it need not be that way with all mutual funds. The Shoven study also presents an illustration showing the after-tax returns of an account in an index-type fund with much lower portfolio turnover. Table 13.2, comparing Fund A, a conventionally managed stock fund, with Fund B, an index stock fund, summarizes Professor Shoven’s findings. Both stock funds earn the same 12 percent pretax return, but Fund A distributes a full 10 percentage points of this return—4 percent as short-term gains and income and 6 percent as long-term capital gains. Fund B distributes just 2 percentage points of its 12 percent return—1 percent as income and 1 percent as long-term gains. Once Shoven accounts for the taxes due on these distributions, Fund B boasts a 2.3 percentage point advantage over Fund A—a 25 percent premium in after-tax return.

Armed with a tax-efficient stock fund, investors can accumulate more capital by inverting Professor Shoven’s unconventional prescription, and holding taxable bond funds inside their pension accounts and tax-efficient stock funds outside their pension accounts. After a 30-year holding period, based on a $10,000 investment—$5,000 in stocks and $5,000 in bonds—the final value would be as shown in Table 13.3.

The use of a highly tax-efficient stock fund, then, would turn the equation upside down. An investor utilizing bonds in the pension account and stocks in a typical tax-inefficient fund outside the pension account accumulates $72,000, a $32,000 shortfall relative to the capital accumulated with the Shoven allocations. But when the same 50/50 strategy utilizes a tax-efficient stock fund, the accumulation totals $112,000, an excess of $8,000 relative to the capital accumulated with the Shoven allocation. The tables have been turned upside down. Using bonds in the pension account changes a shortfall of $32,000 into an excess of $8,000 (along with an estate tax advantage, since the cost basis of the taxable stock account is stepped up to market value at death).

TABLE 13.3 Wealth Accumulated with Use of Tax-Inefficient and Tax-Efficient Stock Funds*

Most investors may well decide to keep some stocks and some bonds in both taxable and tax-deferred accounts. But especially for those investing sizable sums—more than the $10,000 to $12,000 annually that, under current tax law, can be invested in tax-deferred accounts such as a 401(k) plan or a traditional IRA—the Shoven study offers sensible guidance to the optimal allocation of assets between a retirement fund and a conventional savings account. The decision must be a major focus of the investor’s tax strategy.

The Parallax View

Investors must realize the importance of not merely minimizing taxes, but also maximizing after-tax returns. They must consider all three of the spatial dimensions of mutual fund investing: return, risk, and cost. Taxable investors must unfailingly recognize that taxes are costs—and substantial costs at that—and it is high time for mutual fund managers to do so as well. While there seems little need for additional conventional mutual funds offering the same old strategies, there is ample need for new funds designed solely to serve taxable investors. A fixed trust owning a diversified list of 50 U.S. blue-chip growth stocks is one alternative. In this global day and age, a sister fixed trust with a list of 75 of the largest growth stocks in the world is another. Both lists would be handsome. But, whatever stocks are chosen, the fixed trust must be operated at minimal cost, and structured to limit cash flows.

The ideas and concepts in this chapter, however obvious and painfully simple, are fully consistent with my parallax view of the mutual fund industry today. The new fund I’ve discussed is not, like so many funds in recent years, another transitory fad to capitalize on the strategy of the moment. It is based on a durable concept that capitalizes on age-old basics. Instead of focusing on what’s most marketable to speculative investors in the short term, the industry should offer what’s most serviceable to intelligent investors in the long term. The timing of introducing such a fund is risky, but so is the timing of all new funds. The markets of the world, particularly those in the United States, may look overextended today, but my earlier advice applies here: Never think you know more than the market. No one does.

It is high time for mutual fund managers to awaken to the critical issue of taxes, review their investment policies, and consider whether the industry’s 30 million taxable shareholders are getting a fair shake. Mutual funds do not have a monopoly on the affections of investors. If fund managers persist in ignoring the tax consequences of their decisions, investors have the option of owning a diversified list of individual stocks held directly, and maintaining personal control over the realization of gains. Other tax-efficient means of investing are also emerging, notably the unit trusts known as “Spiders” and “Diamonds,” essentially index funds replicating, respectively, the S&P 500 Index and the Dow Jones Industrial Average, and listed on the American Stock Exchange. That competition will, finally, have to be confronted if mutual funds are to remain the investment of choice for America’s families.

TEN YEARS LATER

The Parallax View

Paradoxically, while exchange-traded funds are themselves generally tax efficient, their shares are actively traded by investors, meaning that while the funds don’t distribute gains, their investors are subject to income taxes when they make profitable short- term trades. As noted earlier, the Spiders are now traded with a fury, turning over as much as 40 percent per day.

My conclusions remain: (1) “Investors must realize the importance of not merely minimizing taxes, but also maximizing after-tax returns.” (2) “Mutual fund managers [must] awaken to the critical issue of taxes.” While generation of taxable gains may well be relatively dormant in the aftermath of the lost stock market decade of 1999 to 2009, markets don’t go down forever. What’s more, there’s a high likelihood that in 2010 tax rates on both long-term and short-term gains will be substantially increased. In any event, taxable investors owe it to themselves to emphasize passive index funds, or well-managed, low-turnover, actively managed mutual funds, or funds with substantial unrealized losses on their books.