You may have heard the true story about a young professional baseball player who on the day before income tax returns were due, discovered he had an enormous tax bill. He had invested over $6 million into a group of no-load mutual funds. Everything seemed fine until all of the funds, which included a very well-known index fund, made unanticipated taxable distributions. The athlete had no idea that taxes were due on mutual fund distributions since he, personally, had not redeemed any shares. Needless to say, he was very upset when $400,000 of his investment had to be liquidated to pay taxes. He fired his advisor.
As you know, tax-efficient investment management for high-net-worth clients is not simple. Many an advisor who has recommended low turnover mutual funds or a long-term investment strategy (tactics that are typically associated with tax efficiency) may still get blindsided. Nothing is more maddening to an investor than receiving notice of large capital gains distributions that he was not expecting or even worse, was not aware could occur.
A recent SEC mandate now requires mutual funds to disclose after-tax performance in prospectuses. This may or may not help. SEC “required disclosures” are sometimes confusing, limited in scope, or missing germane information.
Today’s fund managers sit squarely on the horns of a dilemma: Attempting to provide competitive pre-tax returns on one side, while managing a fund’s tax efficiency for taxable accounts on the other. Some believe the two goals are pitted against each other, making it difficult for both to coexist within the same portfolio. Some manage money as if tax efficiency is the ultimate goal; others as if tax efficiency does not matter at all. Butbefore you toss up your hands like fund managers who neglectfully opt to ignore the tax consequences of their portfolio moves, and choose only to concentrate on stock selection and portfolio construction, read on.
When I became an equity analyst for a large institution with over $50 billion invested in equities, a central focus of our investment strategy was to minimize taxable distributions, a valid aspiration. The fund pursued a buy-and-hold strategy resulting in less than a five percent turnover ratio every year and a tax efficiency ratio of more than 90%. While on the surface those ratios looked stellar, what was not apparent to the casual observer was that unrealized capital gains accounted for about 70% of assets under management.
Because of an unyielding adherence to the buy-and-hold philosophy, many of the largest positions in the portfolio were stocks that had been purchased as long as 25 years ago with a cost basis of pennies on the dollar. The fund was handcuffed into a position where it was forced to hold these stocks forever, almost regardless of company fundamentals, valuation, or increased risk associated with significantly overweight positions in tired stocks. If it ever broke from this long-held strategy and sold any of the low-cost shares, the tax-paying owner of the portfolio would have a huge capital gains tax to pay. That taught me that a tax efficiency strategy based solely upon low turnover may not be optimal over the long term.
Many advisors invest time hunting through data looking for funds with low turnover. According to Morningstar, however, some low turnover portfolios (those with an average holding period of three years or more) have produced tax efficiency ratios below 50% over the past five years, an extremely poor record for a widely accepted tax efficiency strategy. In fact, the average tax efficiency ratio of low-turnover equity funds (including index funds) has been fairly mediocre, averaging less than 75% over the last three years. This is not much different than the average ratio of almost 70% produced by all domestic equity mutual funds over this period.
Meanwhile, a fund managed for tax efficiency may produce rates better than 90%, resulting in very meaningful differences in after-tax total returns to fund investors over the long term. Consider that taxes are often the largest cost of owning a mutual fund, reducing average annual returns by about 2.75% over each of the last five years.
Additionally, of low-turnover portfolios with five year records, about 40% have unrealized capital gains accounting for more than 25% of each portfolio, with some exceeding 75% of the portfolio. As you are aware, unrealized gains potentially mean future tax liabilities for your clients. It is this accumulation of embedded unrealized capital gains that allows low turnover portfolios to generate high tax efficiency in the short run, but not necessarily in the long run.
As the professional baseball player found out, you could have an extremely tax-efficient fund for many years in a row; but in the blink of an eye, the manager sells something with a large embedded gain and negates any tax efficiency that was generated over the previous years. It is then up to you as the advisor to explain why to your clients.
The following table compares the Vanguard 500 Index Fund to domestic equity funds (ex-specialty funds) that produced the highest after-tax returns, while maintaining a tax-efficiency ratio of 90% or better over the last three- and five-year periods, and keeping embedded capital gains to 25% or less of the portfolio.