Fund Owners: Prepare for Pain

One of The Motley Fool's biggest criticisms of actively managed mutual funds is their lack of tax efficiency. In the past few years, when the markets have done almost nothing but rise, few people noticed, even when their tax bills came. The evil twin of the wealth effect will come down hard this year, as mutual fund owners who have watched their portfolios decline by double-digit percentage points will start to receive their tax bills, which will have to be paid IN CASH.

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By Bill Mann (TMF Otter)
December 1, 2000

What we have here is an ugly market. People are hearing bad news and taking it hook, line, and sinker, while good news rolls off people's backs like water off a duck. It is the polar opposite from last year at this time. Then we were a Prozac market, now we're all on Quaaludes. We're just plain down.

It seems so stupid. Now's when everyone should be excited about buying, not back in February. But I guess it's too much to ask people to quit looking at the short term since it feels like the market has been dropping for a long time. (News Flash: It hasn't been very long.)

Those vaunted "Fall Rallies" that we heard so much about this summer during the "doldrums" didn't amount to much, did they? In fact, here we are, 21 days left in the fall and, on the back of a Gateway (NYSE: GTW) warning, we're pressing ever lower in many sectors of the market. In people's desire to apply logic to the market, and the pundits' willingness to play along, we've been spoon-fed the concept that there is a cyclical nature to the market that somehow matches the calendar year. But, guess what, Chucko? There is no natural law to the stock market.

Well, almost none, at least. There are timings that are applied, usually in regard to the tax year. Many mutual funds do some tax-loss selling before their fiscal year-end (for most, it is the end of October). Stocks sometimes see a jump due to IRA contributions in January and April. But these things are both short-lived and by no means guaranteed to have an effect.

The other half of the equation, the taxes, are more assured. You transact, you are on the tax schedule (even in non-taxable accounts the transactions are reported).

One of the reasons The Motley Fool is so down on actively managed mutual funds is that they are not tax efficient. This point obviously does not apply to those kept in tax-deferred accounts. If you've got funds in one of those, breathe a sigh of relief and just watch your funds' performance and expense ratios. But, for those who hold actively managed mutual funds in taxable accounts, prepare to feel some real cash-out-of-your-pocket pain this year.

Mutual funds are required, on an annual basis, to distribute all of their capital gains from sales to their shareholders. So, even if you do not sell any of your fund holdings, you still are responsible for the capital gains taxes triggered by the manager's sale of appreciated shares. After the last few years, with the rapid growth in share value in many equities, the capital gains for those sold this year will be enormous. And they must be paid by you, even if your investment in the mutual fund a) began this year and b) has lost money.

By the way, in accordance with SEC rules, mutual fund companies do not have to report the tax-adjusted returns of their funds. So, the boldly expressed one-, three-, and five-year returns that you see in magazines, on TV, and otherwise are not net of taxes. There are proposed rules at the SEC to force fund companies to change how they report to include their tax efficiency, but for now those taxes are not accounted for.

How bad is it? I've prepared some examples to let you know what some of the sample returns are. This sampling is not entirely random; it is taken from among the stock funds considered by Morningstar -- the leading provider of mutual fund information -- to be best-of-breed and that have attracted large investments from the public, with a few outliers for color.

Mutual Fund Performance and Capital Gains Estimates for 2000
                               Return          Tax Per   %Tax 
Name Ticker YTD NAV Share Rate
AIM Constellation      CTSGX  -11.03%  36.04    $1.94    4.1%
Fidelity Select Comps. FSCSX -19.6% 73.84 $5.10 6.9%
PBHG NewOpps PBNOX -15.2% 57.98 $9.03 15.5%
Strong Growth SGROX -10.77% 31.82 $1.69 5.3%
Janus JANSX -12.01% 38.76 $1.24 3.2%
Fidelity Mlnm FMILX -11.06% 40.92 $2.20 5.3%
Berger G&I BEOOX -11.98% 16.98 $0.63 3.7%

So, for someone who owns 1,000 shares of Fidelity's Select Software and Computer Fund, the fund itself has lost in net asset value some $14,400 out of a beginning-year investment of $87,900. These are non-cash losses, meaning that the buy-and-hold investor only feels this pinch when he looks at his portfolio statement. But, to add serious insult to injury, this fund holder will also be hit with a tax bill of $5,100 (assuming the 20% tax bracket for the long-term capital gains and 39.6% for the short-term capital gains).

That's a nice vacation or a year at your state's university, gone, on top of the paper losses incurred in the portfolio. Thus, the beauty of index funds. Although they might not be sexy, they might not appreciate each and every year (the S&P 500 is down nearly 8% for 2000), they almost never generate taxable events. Vanguard's S&P 500 Index fund generated one capital gain event ever, $0.09 a share. Vanguard's management was quite displeased.

Investors of all colors, whether they hold mutual funds or not, need to be cognizant of the effect that churn can have on a portfolio. Unfortunately, when the portfolios are going up, most people tend to ignore the effect. But, just as we want our companies to be prudent with their cash, so do we need to understand the depressing effect that tax inefficiency can have on our long-term returns.

The $5,100 an investor will have to pay for his mutual fund taxes this year will be painful, but if we compound that money at the historical return of the S&P 500 for 20 years, he's actually passed up $41,125 on that single year's tax burden. The thing is, it is possible that this shareholder is paying the same percentage of taxes each year.

And all in the quest of beating the S&P 500. If you are not interested in managing your own money, do yourself a really big financial service -- buy an index fund.

Fool on!

Bill Mann, TMFOtter on the Fool Discussion Boards