The Value of Tax Efficient Investments

Abstract

The authors start by observing that, in 2004, mutual funds distributed $55 billion in capital gains to shareholders. Approximately 40 percent of these distributions were paid to taxable accounts, with shareholders paying federal income tax on these distributions at a rate of 15 to 35 percent depending on their income class; some also paid state taxes. The article examines the impact of taxes on mutual fund and stock index returns. Using after-tax return data from Morningstar, it provides updated insight into the relationship of taxes and after-tax investment returns based on reported investment results. The analysis suggests there may be opportunity to increase return through tax management. The authors believe the turnover relationship they identify is controllable and repeatable, even if fully exploited and do not believe the relationship is a time period phenomenon since active managers as a group have historically had higher turnover and have not demonstrated a significant effort to change turnover practices. In the continual quest to outperform, managers may best serve shareholders by focusing on after-tax alpha rather than pre-tax alpha, and specifically by controlling turnover.

TOPICS: Mutual funds/passive investing/indexing, performance measurement, legal/regulatory/public policy