Morningstar's Tax Cost Ratio Tool

The taxman cometh. But he need not taketh away. With that in mind, Morningstar has developed a new measure to help investors better gauge a fund's tax efficiency--the Morningstar Tax Cost Ratio.

Why is tax efficiency so important to fund investors? Morningstar research has consistently shown that many fund managers have fallen down when it comes to tax efficiency. In their zeal to post eye-catching pretax returns, they've done a poor job of harvesting losses to offset capital gains or keeping a lid on turnover so that gains are taxed at more favorable long-term tax rates.

As a result, investors in taxable accounts--who have no control over how deeply they are taxed on capital gains and dividend distributions--have felt the pinch of the tax collector over time. In fact, studies have revealed that taxes wipe out roughly two percentage points of stock funds' annualized pretax returns for investors in the highest tax bracket.

Morningstar has introduced a variety of data points to help investors quantify the tax hit that funds have taken in the past or could take in the future. One such metric is the tax-adjusted return, found in the tax analysis section of a fund's Quicktake Report. That measure reflects the impact of taxable distributions on returns, assuming an investor continues to hold the fund shares at the end of the period. Using measures such as this, investors in taxable accounts can compare funds' aftertax performance to determine which do a better job of keeping the most money possible in investors' pockets.

What Is the Morningstar Tax Cost Ratio?
The new tax cost ratio represents the latest addition to our suite of tax-efficiency metrics. Unlike our current data points, which help investors compare funds' aftertax performance on an absolute basis, the tax cost ratio assumes that tax efficiency, like all things, is relative. That is, the tax cost ratio looks beyond the sheer magnitude of aftertax returns and peeks under the hood to see just how effective management has been in keeping taxes under control. 

How the Tax Cost Ratio Works
The tax cost ratio compares a fund's load-adjusted, pretax return (PTR) to its tax-adjusted return (TAR). The resulting number represents the percentage of an investor's assets that are lost to taxes.

To illustrate, let's consider the five-year annualized returns of large-growth standout American Funds Growth Fund of America

(AGTHX):

Pretax Return (PTR) = 6.52%

Tax-adjusted Return (TAR) = 4.44%

Tax Cost Ratio = [ 1 - ( (1+TAR) / (1+PTR) ) ] x 100

= [ 1 - ( (1+0.0444) / (1+0.0652) ) ] x 100

= [ 1 - ( 1.0444 / 1.0652 ) ] x 100

= (1 - 0.9805) x 100

= 0.0195 x 100

= 1.95%

In this case, taxes have consumed nearly 2% of investors' assets over the trailing five years. This metric is also found in the tax analysis section of the fund Quicktakes.

How to Use the Tax Cost Ratio
So you’ve got a fund’s tax cost ratio in hand. What now? Continuing with the previous example, the most logical question to ask about the fund’s 1.95% tax cost ratio is how it stacks up. Is it obscenely high? Spectacularly low? Or somewhere in between?  

It's not possible to draw a telling conclusion about a fund’s tax efficiency by examining its tax cost ratio alone. To make it meaningful, one must compare the fund's tax cost ratio to a relevant benchmark. In this case, American Funds Growth Fund of America's tax cost ratio is slightly higher than the large-growth category norm, meaning that it has been slightly less tax efficient than its average peer.

(Note: Morningstar premium subscribers can use the Premium Fund Selector to quickly determine the average tax cost ratio in a given category. For instance, to pinpoint the average large-growth fund's five-year tax cost ratio, you could create a screen in Premium Fund Selector using the following criteria:

• Fund Category = Large Growth
• 5 Yr Tax Cost Ratio < Category Average

After displaying the results of this screen, select the "Risk and Tax Data" option from the "View" drop-down menu. The category average appears at the bottom of the "5-Year Tax Cost Ratio" column.)

Given this, investors in taxable accounts should disqualify the Growth Fund of America as an option, right? Not necessarily. That's because even a relatively tax-inefficient fund like this one can still post aftertax returns that beat the majority of peers. And that's exactly the case here, as the fund's 4.44% five-year aftertax return bests nearly all of its large-growth peers. Thus, investors looking to maximize their aftertax return certainly wouldn't want to dismiss it out of hand.

That said, maximizing aftertax returns isn't necessarily the be-all, end-all for every investor. In fact, some would argue that cherry-picking the best aftertax performers is little more than performance-chasing in disguise. For instance, had investors sought the highest aftertax flyers in the domestic-stock universe in the late 1990s, they might very well be sitting right now on a downtrodden large-growth or technology offering--hence the danger of relying on aftertax return measures alone.

Efficiency Going Forward
For others, the challenge of seeking out a tax-efficient fund is far more prosaic: They simply don't have the luxury of picking and choosing from the cream of the crop in a category because their choices are limited. Thus, the decision boils down to which funds provide the greatest assurance of tax efficiency going forward.

That's where the tax cost ratio can come in especially handy. It gives investors one more way to measure management's effectiveness in keeping taxes to a minimum. The more committed a manager is to limiting the tax bite--as evidenced by the relative superiority of a fund's tax cost ratio--the more confident investors can be that taxable distributions will be kept in check going forward.

For example, in a case involving two funds--such as Clipper Fund (CFIMX) and Ameristock Fund --that have posted similar aftertax returns, the tax cost ratio measure could well tip the balance in favor of one fund or another. In this case, Ameristock's 0.66% tax cost ratio blows Clipper's 3.05% out of the water, suggesting that Ameristock's management will likely do a better job in the future of keeping taxable distributions to a bare minimum.

The tax cost ratio also puts the costs of taxes into meaningful perspective. Over time, investors have found expense ratios to be a useful expression of a fund's cost-effectiveness. The lower the ratio, the cheaper the fund and, all else being equal, the better a fund's returns over time. In a sense, taxes represent just another variant of fund expenses. Viewed in that light, what better way to illustrate the impact of taxes on investors' assets than to express a fund's tax efficiency as a percentage of assets similar to a fund's expense ratio? Thus, with the new tax cost ratio measure, investors can evaluate a fund's tax and operating costs in familiar and meaningful terms to better quantify the full impact they have on returns.

Finally, as explained further below, the tax cost ratio marks a significant improvement over Morningstar's former measure of tax efficiency--the Morningstar tax efficiency ratio.

How the Tax Cost Ratio Improves upon the Morningstar Tax Efficiency Ratio
In 1993, Morningstar introduced the tax efficiency ratio, which was calculated by dividing a fund’s aftertax annualized return by its pretax return. Thus, the higher a fund's tax efficiency ratio (which was expressed as a percentage from 0 to 100), the more tax efficient a fund had been. One of the first measures of its kind, it provided a useful, back-of-the-envelope way of determining what percentage of a fund's returns were finding their way into investors' coffers after Uncle Sam had gotten his piece.

However, it suffered from several notable shortcomings, which limited its usefulness. Among them:

• Tax efficiency could not be calculated when both or either returns were negative.For example, on a pretax basis the Janus Fund JANSX has lost 19.2% over the trailing three years. The fund's aftertax loss during that same period is 19.7%. Thus, the fund's tax efficiency ratio computes to a quite meaningless 102.6%. N/I Numeric Investors Emerging Growth Fund NIMCX serves as another example. That fund posted a 6.3% five-year annualized pretax return but lost 0.50% on an aftertax basis, making its tax efficiency ratio an incongruous -7.9%.

The new tax-cost ratio eliminates these blind spots by expressing tax efficiency as a percentage of assets rather than returns. Thus, investors can now evaluate the tax efficiency of the Janus Fund (1.62%, which trails the large-growth category norm), N/I Numeric Emerging Growth Fund (3.20%, which lands in the small-growth category's bottom quartile), and any other fund for which useful tax-efficiency data was lacking in the past.

• The tax-efficiency ratio distorted tax efficiency when returns were very small.For example, Van Kampen Emerging Growth Fund ACEGX has posted a 1.2% five-year annualized pretax return. That figure dwarfs the fund's modest 0.2% aftertax return. Despite losing only one percentage point of returns to taxes, the fund's 16.7% tax efficiency ratio makes the fund look highly tax inefficient.

The new tax cost ratio rectifies this problem as well. Using the fund's 1.83% three-year tax cost ratio as a measuring stick, investors would learn that the fund's tax efficiency is roughly equivalent to that of its average peer.

By remedying these shortcomings, the tax cost ratio should greatly improve the accuracy and meaning of tax-efficiency data going forward. And since Morningstar will calculate the tax cost ratio for multiple time periods (three, five, and 10 years), it should be far easier to compare a fund's tax efficiency over time.

The tax cost ratio adds yet another useful piece to the mosaic of data points that investors can use in researching a fund's tax efficiency. Used in conjunction with other tax-performance metrics, it should help investors to peer beneath the surface and meaningfully gauge management’s success in minimizing taxable distributions.