Vanguard 1, Fool 0 (Fool on the Hill) December 2, 1999

An Investment Opinion

Vanguard 1, Fool 0

By Bill Barker (TMF Max)
December 2, 1999

It's December, so that must mean a couple of things. First, no doubt you're all counting the days until I deliver my annual heartwarming holiday season classic, "How the Merrill Lynch Stole Christmas." Even more than that, this time of year is known for giving and receiving. While giving is welcome during most of December, there are some annual gifts that show up right about now that you really don't want to receive. Fruitcake, of course, is the most obvious example, but additionally there is the annual "gift" that arrives from your mutual fund company -- the "gift" of capital gains distributions.

Capital gains are the often overlooked and rarely mentioned downside of selling stock at a profit, and typically at the end of the year capital gains are distributed to mutual fund shareholders. The capital gains, for which taxes have to be paid by the mutual fund shareholder, can be quite significant as most mutual fund managers are fairly active at trading and are not real models of buy-and-hold investing.

Mutual funds on average sell out of about three quarters of their holdings each year, and many funds manage to annually turn over more than 100% of their holdings. Capital gains distributions have for many years been sort of the unmeasured dirty little secret of the dirty big mutual fund industry. Fortunately for Fools, the unmeasured aspect is suddenly not as true as it used to be, thanks to the work of the phenomenally shareholder-oriented people running Vanguard.

Properly determining the tax consequences of mutual fund capital gains distributions had been a vexing problem, due to differing income levels, state taxation issues, and other factors that produce different tax brackets for different investors. This difficulty, perhaps, has been one of the shields that mutual fund companies have brandished when queried about their after-tax results. Vanguard decided to cut through this Gordian knot by simply assuming the highest tax bracket applicable and figuring out how investors would have done when holding its mutual funds in taxable accounts.

Vanguard notes in its After-Tax Returns for Vanguard Funds as of September 30, 1999, that when mutual fund companies (including itself) report pretax returns, they are assuming that all distributions received (both income dividends, short-term capital gains, and long-term capital gains) are reinvested in new shares. This is pretty common -- most mutual fund shareowners have their dividends and capital gains distributions reinvested for them whether they are aware of it or not. In determining after-tax returns, Vanguard assumes that distributions are reduced by any taxes owed on them before reinvestment. In other words, Vanguard assumes that the real world exists -- which is a bold step in the money management world.

When calculating the taxes due, Vanguard used the highest individual federal income tax rates at the time of the distributions. Currently those rates are 39.6% for dividends and short-term capital gains, and 20% for long-term capital gains. Taxpayers in lower tax brackets thus would not have had their total mutual fund returns reduced by quite as much as the Vanguard tables show, though those who have additional state taxes to pay would see their results diminished even more.

The results for any Fools who hold mutual funds in taxable accounts (i.e., outside of IRAs, or 401(k), 403(b), or 457(b) accounts) can be quite dramatic. Compare the results of the Vanguard 500 Index Fund (commonly referred to around here as "The Index Fund"), with the group of managed mutual funds that invest in large cap companies. (Results are through September 30, 1999.)

                         1 Year            5 Year             10 Year
                    Pretax  After-tax  Pretax  After-tax  Pretax  After-tax
Vang. 500 Index Fd  27.84%  27.00%     24.95%  23.90%     16.67%  15.46%
Avg. Large Cap Fd   24.67%  23.07%     20.37%  17.90%     14.07%  11.62%
I've bolded the 10-year returns, as this should give you the best perspective to see by just how much reported mutual fund results are misleading for those who are holding the shares in a taxable account. Figure that, on average, the way that mutual fund results are reported, they overstate by about 2.5% the real after-tax annual returns provided to shareholders if the funds are held in a taxable account. Since managed mutual funds trail the market's average returns by about 2.5% before taking taxes into account, this means that managed mutual funds shareholders have received returns of about 5% less per year than the S&P 500 index provides.

If you start multiplying that shortfall out over lengthy periods of time, you'll find yourself in real pain. Over 50 years at a rate of 15.46% (the index fund after-tax rate) $1,000 will compound to over $1.32 million, but to only $240,000 at 11.62% (the large cap blend fund after-tax rate). Over 50 years, the "help" of professional money managers would eat up 82% of the market's returns. Yikes!

The lesson in all of this is that if you hold managed mutual funds at all as part of your portfolio, you definitely are best off holding them in tax deferred accounts, such as an IRA or 401(k). If you do hold your managed mutual funds in a tax-deferred account, you're still getting the poor results of managed mutual funds, but you're getting the pretax poor results, which aren't as bad.

Much exalted praise has to go to Vanguard for being, well, in the vanguard on this issue. No one else is reporting their funds' returns the way Vanguard is. Longtime readers of Foolish prose will know what happens next in an article such as this. Right about now, the author should launch into a scathing attack on the other mutual fund companies on Wall Street and elsewhere that are not reporting the after-tax results of their mutual funds, and the reasons why failing to do so is Wise. You know, I'd really like to fulfill my contractual obligation to insert such a screed, and I've got a great little paragraph in my head that would do the job quite nicely. It's got all the tricks -- sarcasm, dramatic irony, metaphor, bathos, parody, litotes, satire. It's a heckuvan attack.

Unfortunately, it can't be used.

Not yet anyway.

For you see, we here, we Fools, are not yet reporting the results of all of our own portfolios with any recognition that after-tax results differ from pretax results. Now, the Rule Maker portfolio actually does report on an after-tax basis. The DRiP portfolio has never had a sale, so it's okay. The Foolish Four portfolio has only been a real money portfolio for less than a year, so it too has no capital gains, though it will very shortly. For the Rule Breaker, the Boring Port, and especially for the Foolish Four, there are some significant tax consequences to past and/or planned sales within those portfolios, and currently there is no gauge given to how real-world tax payments would affect the past results of those portfolios.

Accordingly, until we catch up with Vanguard on providing the most complete set of statistics to investors, we're in no position to start wagging our Foolish fingers at anyone else on this issue.

This round goes to you, Vanguard.

For the time being.

Related Link:
  • The Truth About Mutual Funds
  • The Truth About Mutual Funds: Taxes
  • Boring Portfolio Report, 10/21/98: Turnover Kills