In Search of Tax Efficiency

Taxes are an important, but often overlooked, cost for investors who hold mutual funds in a taxable account. Most fund companies gauge their managers’ success on pretax performance and provide incentives accordingly. As a result, managers often ignore the potential tax implications of their actions. But taxable investors bear the cost.

Mutual funds are required to distribute all of their capital gains to investors each year. This means that investors are stuck with the tax liabilities of those gains even if managers reinvest them and investors don’t sell the fund. In contrast, investors don’t realize capital gains on individual stocks until they sell them. Although the same tax rate applies in both cases (assuming the holding period for both exceeds one year) and current tax distributions reduce investors’ future tax liabilities, deferring taxes allows the investment to compound at a higher aftertax rate.

For example, consider two funds that generate an annualized pretax return from capital gains of 6% over 10 years, both of which are taxed at the highest long-term federal rate of 23.8% (which includes the 3.8% Affordable Care Act surtax). Fund A distributes all of its capital gains each year, while Fund B does not distribute any gains until the end of the investment period. The annualized aftertax return for each fund is as follows:

Fund A = 4.60%, Fund B = 4.86%

Most funds do not realize all of their capital gains each year, but higher turnover tends to increase the likelihood and magnitude of capital gains distributions. This hurts aftertax returns because it reduces the portion of the tax liability that investors can defer and could trigger greater short-term distributions, which are taxed at higher (ordinary) rates. For instance,

Just as high turnover can reduce tax efficiency by increasing capital gains distributions, large dividend distributions reduce tax efficiency because they create an immediate tax liability. Therefore, it may be best to leave dividend-income and high-turnover strategies in tax-sheltered accounts.

The Morningstar Tax Cost Ratio makes it easy to compare tax efficiency across different funds. It estimates the percentage of each fund’s assets that are lost to taxes each year. The interpretation is similar to an expense ratio. It is calculated as: 100*[1-[(1+Ra)/(1+Rp)]], where Ra is the aftertax return and Rp is the pretax return. The estimate of aftertax returns uses the highest federal rate, but it ignores state taxes and assumes that investors do not sell the fund. Over the past decade, the average fund in the large-blend Morningstar Category had a tax-cost ratio of 0.88. The corresponding figures for Hartford Capital Appreciation and Primecap Odyssey Stock were 1.49 and 0.36, respectively. Investors can find the Morningstar Tax Cost Ratio, estimated aftertax returns, and estimated potential unrealized capital gains on the tax tab under each fund on Morningstar.com.

Tax-Efficient Options

Because broad, market-cap-weighted index funds tend to have very low turnover, it is not surprising that many are very tax-efficient. For example,

Low turnover certainly contributed to this fund’s tax efficiency, but it also benefited from a structural advantage. Vanguard offers a separate exchange-traded fund share class of this fund, which allows it to transfer low-cost-basis shares out of the portfolio through a tax-free in-kind redemption transaction with the authorized participants. In this transaction, the managers deliver the fund’s underlying holdings, in lieu of cash, to an authorized participant who wants to withdraw assets. This makes it easier for managers to avoid realizing capital gains (though capital gains distributions are still possible). Vanguard is the only U.S. firm that offers a hybrid ETF/mutual fund structure. However, most U.S.-listed equity ETFs offer this structural tax advantage.

Despite this tax advantage, most traditional active managers have been hesitant to launch versions of their strategies in an ETF wrapper because, in doing so, they would be required to disclose their holdings daily. This could be problematic when managers build or exit positions, which can take several weeks to complete, because they would be broadcasting their moves to the market before they are complete. Other market participants could use this information to trade ahead of the managers, causing them to receive less-favorable market prices.

In order to address this problem, Eaton Vance has developed a structure called an exchange-traded managed fund, and it would allow managers to disclose their holdings on the same schedule as mutual funds. Like a mutual fund, it would strike a net asset value at the end of each day, but it would benefit from the in-kind redemption process that ETFs commonly use. Funds with this new structure have not yet come to market, so, for now, tax-conscious investors who favor active management should stick with low-turnover managers or tax-managed strategies.

Primecap Odyssey Stock (0.62% expense ratio) is a compelling low-turnover strategy with a good record of tax efficiency, though it is not explicitly tax-managed. The managers look for stocks with underappreciated growth potential and tend to hold on to these names for many years, helping to mitigate capital gains distributions. The fund’s estimated aftertax returns ranked in the category’s top decile over the past decade.

Tax-managed funds take more proactive steps to maximize aftertax returns, such as harvesting capital losses to offset gains elsewhere in the portfolio, delaying the sale of securities with capital gains, and, in some cases, modestly underweighting dividend-paying stocks.

AQR Tax-Managed Large Cap Multi-Style QTLLX (0.47% prospectus expense ratio) takes bigger active bets, targeting U.S. stocks with strong value, momentum, and profitability characteristics. This can be a high-turnover strategy, which isn’t great for tax efficiency. In order to improve aftertax returns, it explicitly estimates the tax cost of trading (along with other transaction costs). If these costs exceed the estimated benefit from trading each stock, AQR won’t execute the trade. This direct approach to tax management effectively aligns managers’ actions with taxable investors’ interests. (Full disclosure: I own AQR TM International Multi-Style QIMLX, which follows the same approach in foreign developed markets.)

Tax management doesn’t always yield better aftertax returns. For instance, although taxes took a smaller bite out of

Tax-loss harvesting could modestly reduce the efficacy of a value strategy, as previous laggards may become cheaper and poised to outperform. The fund’s strategy of holding on to more stocks as they migrate out of its targeted value zone in an attempt to defer capital gains taxes also gives it a slightly less pronounced value tilt than its non-tax-managed counterpart. This could further detract from performance when value stocks outperform. However, DFA Tax-Managed US Targeted Value is still a solid long-term option for tax-conscious investors who want exposure to small-cap value stocks.

Summary

• Most mutual fund managers do not focus on aftertax performance.
• Investors should favor ETFs, low-turnover strategies, and tax-managed funds in their taxable accounts. High-turnover and dividend-income strategies are best suited for tax-sheltered accounts.
• A well-executed tax-management strategy often, but not always, leads to better aftertax returns.