Mutual Funds: Costs

A Lesson in Tax Efficiency

Mutual Funds

By Randy Befumo

The poor performance of the average mutual fund relative to the S&P 500 on a pre-tax basis has been highly publicized over the past few years. A story that has been told a lot less is that on an after-tax basis, the returns get even worse. Index funds outperform money managers not only through minimizing expenses, but by staying invested and not changing those investments very often. Simply looking at the capital gains distributions in an index fund relative to other professionally managed money provides an object lesson about how low turnover and low cash balances can provide solid returns.

Because the Standard & Poor's 500 is an index constructed by the editorial board of Standard & Poor's, index fund managers have an advantage most professional money managers do not. Other than the cash they might need for redemptions in the fund, the question of what stocks to buy is just a matter of looking at the weightings in the S&P 500 and distributing the money. The question of what to sell is even more elementary, as the index fund only needs to sell when the index is changed. On average, due to mergers, acquisitions, bankruptcies, and general corporate distress, the S&P 500 can have anywhere from five to fifteen changes during a given year. Compared to the average mutual fund, however, five to fifteen "sells" is an extraordinarily low number.

Looking at the capital distributions in the Vanguard Index Trust 500 for 1997, every share saw 14.5 cents of short-term capital gains and 40.5 cents worth of long-term capital gains. Given that the Vanguard Index Trust 500 closed the year with a net asset value of $90.07 per share, you can see that this meager 55 cents in taxes barely reduced the returns in either fund. Of course, if an investor had sold shares of the fund, they would have to recognize tax consequences beyond the distributions. However, for individual investors creating wealth over long periods of time through the magic of compounding, on an after-tax basis the more money you can keep invested, the more value you can create. Just as every dollar in fees you fork over to invest hurts your returns, every dollar you give to the tax man does just the same.

By way of comparison, Vanguard's Windsor fund saw a short-term gain distribution of 86 cents and a long-term distribution of $2.02. With a net asset value of $16.98 at the end of 1997, Windsor generated 6.4 times the tax burden per share but had a net asset value that was 81% lower. Not only did Windsor only return 21.98% in 1997 versus 33.35% for the S&P 500, but much of what it did return was automatically taxed through capital gains distributions, shaving 15% to 36% of those returns off the top depending on the investor's tax bracket. Although most mutual fund companies say that they do not stress after-tax returns because each individual tax situation is different, if after-tax returns were reported the performance gap between the average mutual fund and the S&P 500 would increase substantially.

An ancillary benefit of not selling very often and having a preset investment plan is that you can keep the amount of money you have in low-yielding cash to a minimum. An index fund can keep 98% to 99% of its money invested, whereas the cash position of the average mutual fund is much higher. With only 90% to 95% of your money invested, you actually need to beat the index return with the money that has been invested to match the return of the index in your fund. So to match the return of the index, money managers not only need to outperform in order to make up for higher expenses, but they also have to outperform because they cannot be 100% invested. On top of that, even if they do breakeven or beat the market on a pre-tax basis, they can destroy this value for individual investors through capital gains distributions that make most of the gains taxable.

The lesson here for individual investors who want to go it on their own is pretty simple, but pretty powerful. Tax efficiency and maximizing money in the market that is compounding value is a key part of generating long-term, excess returns. In fact, when you calculate the effect of taxes, the margin of outperformance that many short-term oriented investors say they enjoy is whittled down. Although the standard defense is that you have to sell sometime, the reality is that if the money compounds over long periods of time and you capture lower tax rates for being a longer-term holder, on an after-tax basis the difference can be quite profound. That does not even include the possibility if you own a dividend yielding stock that you could just capture the rising income generated by the stock to live on and leave the equity untouched -- and untaxed -- to pass on the higher cost basis to your heirs. This is what the S&P 500 Index is essentially doing, and why it is such tough competition for professionally managed money.

By understanding why the S&P 500 index fund can be a superior investment vehicle, you can gain insight on how to invest in order to be a superior investor. By keeping expenses low, minimizing your tax burden, and maximizing the amount of money in the market, the average S&P 500 index fund kicks the pants off professionally managed money. Everything you can do as an investor to replicate this and create powerful returns on an after-tax basis is something that will create excess returns for you -- returns above and beyond what the market average. In the end, it is these after-tax, excess returns that are the object of the investing. Anything that does not produce similar results has to be questioned.

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