A Long Shadow - tax efficiency of mutual funds - Brief Article

Kiplinger's Personal Finance Magazine,  June, 2000  by Steven T. Goldberg

• E-mail
• Print
• Link

FUNDS | Except over long periods of time TAX EFFICIENCY is irrelevant.

TAX EFFICIENCY ranks right beside motherhood today. By a vote of 358 to 2, the U.S. House of Representatives passed a bill in April that mandates mutual fund companies tell you how tax-efficient their funds are. That is, funds must indicate how much of their gains end up in the government's pocket via taxes you pay on dividends and capital gains. Before the bill passed, the Securities and Exchange Commission proposed new regulations that would accomplish the same goal. Says SEC chairman Arthur Levitt: "Recent estimates suggest that more than two-and-one-half percentage points of the average stock fund's total return are lost each year to taxes."

The sound and fury over tax efficiency is overdone. For one thing, predicting future tax efficiency is difficult. A fund may be tax-efficient one year because the manager holds on to stocks that have risen a ton. The next year the manager may sell those winners, making the fund very tax-inefficient. Or a new manager may take over and sell most of the old manager's holdings. "Past tax efficiency is a pretty lousy predictor of future tax efficiency," reports Russel Kinnel of Morningstar.

Nor is the amount of trading a fund does a good indicator of its future tax efficiency. Example: Van Wagoner Emerging Growth, with a turnover of 353% last year, has never paid a capital gain because it sells mainly losers.

By comparison. What's more, for most investors tax efficiency hardly matters. Suppose you're in the 31% tax bracket and have a choice between two funds, each of which earns 11% annually including 2% in dividends. One is perfectly tax-efficient-that is, like Van Wagoner Emerging Growth or a fund marketed as "tax managed," it never pays out capital gains. The other is a typical stock fund, paying out half its gains every year, 1.5 percentage points in short-term gains and three percentage points in long-term gains.

Over three years, a $10,000 investment in the tax-efficient fund nets you $12,850, versus $12,767 for an ordinary fund, assuming you sell both funds at the end of that period. Over five years, the tax-efficient fund nets you $15,278, versus $15,068 for the ordinary fund, an annualized difference of just 0.3 percentage point.

Only over a truly long period, such as 20 years, does tax efficiency's compounded effect have time to pay off: The tax-efficient fund would net you $61,314, versus $54,603 for the ordinary fund. Says Joel Dickson of Vanguard Group, who computed the results: "If you're an average investor who sells a fund every three years or so, you lose most of the benefits of tax efficiency."

COPYRIGHT 2000 The Kiplinger Washington Editors, Inc.
COPYRIGHT 2000 Gale Group