Wall Street Self-defense

Taxes You Shouldn’t Pay

How your mutual funds are raising your IRS bill.

Illustration by Robert Neubecker. Click image to expand.

Own a mutual fund? If so, a couple of months ago, you probably got a note like this:

Dear Fund Owner: We are pleased to report that your fund did well in 2005. Thanks to the tireless efforts of our analysts, traders, and portfolio managers, we beat the market … 

Well, actually, you probably didn’t get a note like that, because most funds lag the market, but you probably got one trumpeting some fund feat or other. What you almost certainly didn’t get was a note like this:

Dear Fund Owner: We are sorry to report that your fund did poorly in 2005. Oh, we beat the market, but of course this performance was pretax. We would like to imply that pretax performance matters (everyone else does), but it doesn’t. Most of our shareholders have to pay taxes, and after taxes, our fund probably cost you a pretty penny.

It’s no mystery why you don’t get notes like this, even though they describe the reality for most fund owners (except for the market-beating part). Unless you own your fund in a tax-free retirement account, however (which some investors do—thus providing fund managers with an excuse), reading about pretax performance is a self-deluding waste of time. Instead, skip to the after-tax punch line, which, sadly, you probably won’t find in the annual letter. Because if you don’t, you’ll just be setting yourself up to get socked with an unexpected tax bill.

Like other investing costs—management fees, brokerage commissions, transaction costs, etc.—taxes have a big impact on investment returns. A 2000 study by First Quadrant L.P. confirmed the familiar finding that index funds outperform most mutual funds: In the 20 years through 1998, only 22 percent of U.S. equity funds beat Vanguard’s S&P 500 index fund. Of course, these numbers—and most such comparisons—actually overstated the performance of the equity funds, because they were pretax measures. Actively managed funds (run by stock-pickers) generally trade more often than index funds, and trading usually increases tax costs. So, First Quadrant took this study a step further and analyzed after-tax performance. It concluded that, after tax, only 16 percent of the funds did better than the index. The handful of funds that managed to beat the index, moreover, did so by far less (+1.46 percent per year) than the mediocre majority lagged it (-2.67 percent per year).

First Quadrant’s study also analyzed the amount of fund underperformance that was directly attributable to poor tax management. It found that the tax inefficiency of the average underperforming fund cost its owner -0.56 percent per year. Doesn’t sound like much? On a $100,000 investment, at a 10 percent rate of return, even a -0.56 percent annual lag would end up costing you $130,000 over 25 years. 

Tax costs come in several flavors: short-term capital gains (positions sold in less than one year), long-term capital gains (positions sold after more than one year), dividends, and deferred capital gains (eventual sale of fund shares). Under the current tax code, by far the most expensive of these is short-term capital gains. Once federal, state, and local tax collectors have taken their cut, investors in the top tax bracket can end up keeping less than half of their short-term return.

The first rule of tax management, therefore, is to avoid taking short-term gains. This means either never selling winning stocks or funds held for less than a year, or always offsetting such gains with short-term losses. It is the failure to follow this simple rule that clobbers the after-tax performance of many mutual funds. It is the same failure that often dooms today’s hottest investment vehicle—the hedge-fund—to after-tax mediocrity.

The goal of most hedge funds is to make money now. This means trading at a pace that makes even hyperactive mutual-fund managers seem patient. Hedge funds also avoid dividend-paying stocks, because what makes money now is price appreciation (in hedge-fund land, dividends are for grannies and sissies). As a result, successful hedge funds often rack up mountains of short-term gains that come with a huge tax load.

How much can short-term taxes eat into performance? Let’s assume that your favorite hedge fund generates annual pretax gains of 10 percent a year and all of the gains come from short-term trading. Assuming a 50 percent total tax liability—and no other fees (dream on)—a $100,000 investment would appreciate to $339,000 after 25 years. Not bad!

Not bad until you compare this to the after-tax performance of a fund that generates the same 10 percent return from dividends and long-term gains. Assuming a 20 percent annual tax liability and no fees, the same $100,000 investment would grow to $685,000 after 25 years—more than twice as much.

Looked at differently, to generate the same after-tax wealth, your hedge fund would have to generate an annual pretax return of 16 percent, versus 10 percent for the long-term fund (and, again, that’s before costs). This is an extreme case—tax situations vary, most hedge funds generate some long-term gains, and almost all funds have some short-term turnover—but suffice it to say the following: Pretax returns are not created equal, and the more you or your fund manager trade, the more you have to beat your benchmark by just to come out even.

So, what’s the answer? Unfortunately, for most people, it’s not just “buy index funds.” Yes, buying an index fund is almost always a better after-tax choice than buying an average mutual fund or hedge fund. On the tax front, however, even most index funds leave something to be desired, because they aren’t tailored to your particular tax situation, and they don’t actively “harvest losses” that can be used to offset unavoidable long-term gains. The answer is to manage your entire financial life from an after-tax perspective. Bone up on tax-efficient strategies. Never make decisions without analyzing tax consequences. Ignore pretax performance. Consider tax-managed funds. Hire advisers who understand that, along with other investment costs, taxes are one of the few elements of your return that you can control. And when you get that annual victory note crowing about your fund’s pretax returns, just dump it in the trash.