Taxes — The Hidden Pitfall for Investors

By  E. Scott Batchelor, Jr.

Performance is the great leveler in the investment world. Most people are less concerned with how the vehicle looks than with how fast it travels, how much it costs, and how it will hold up in a crash (and yes, all three puns intended). However, measuring performance is not always as simple as one might think; especially when you take into account the obscurity under which many financial institutions operate. For instance, say you read that Mutual Fund XYZ had a 20% return for 2006. “Wow!” you’re probably thinking. Well, what if I told you that the fund had a 2% management fee, a 1% 12b-1 fee and you had to pay out 5% in capital gains taxes. That 20% just turned into 12%, underperforming the S&P 500 by almost 4%. Statistics can always be manipulated, so I’ve devised a common sense formula to measure “net to client” performance: how much goes back into my wallet divided by what I gave someone to invest. Or, more academically:

The topic of this discussion is the tax liability created by investment vehicles. Tax efficiency is one of the most under-emphasized metrics used to evaluate investments. Perhaps because taxes are an issue between the client and the IRS, managers are often appraised on their pre-tax performance, with no regard as to the size of the tax bill they created. This paper will attempt to enlighten the average investor as to what extent taxes are cannibalizing their performance, and what they can do about it.

Investment Gains and Tax Treatment

First, a brief discussion of which tax rates apply to which type of investment gains:

• Dividends- any dividend received: 15%

• Interest- this covers any interest income from a bond or money market fund: taxed at the individual investor’s income tax rate (we’ll assume 35%)

• Realized Gains, Long Term- stocks held longer than 1 year and sold for a gain:15%

• Realized Gains, Short Term- stocks held less than 1 year and sold for a gain: taxed at the individual investor’s income tax rate (we’ll assume 35%)

Realized losses get a little trickier, but for the purpose of this discussion, you should know that an investor can net a realized loss against a gain to offset a tax liability. Furthermore, investors may take up to an additional $3,000 in losses to reduce adjusted gross income. Anything over $3,000 can be carried indefinitely to offset any future tax gains. An example here would probably help:

Suppose at the end of the year, you’ve taken $6,000 in capital gains from the sale of stocks in your portfolio. Additionally, assume you have $10,000 in losses from the one bad stock you sold. Netting these against each other, you still have a $4,000 realized loss. That means, you may use $3,000 of it to reduce your taxable net income and carry $1,000 into the future to reduce capital gains in your portfolio next year. Or, for another example, suppose you received $500 from dividends, $300 from interest income, and had a $6,000 capital gain ($2,000 of which came from short term holdings and $4,000 came from long term). Your approximate tax bill would be:

So, even though your total portfolio gain was $6,800, you only got to keep $5,320 or 78%; the other 22% was consumed by taxes. Another way to look at this would be if your portfolio had a 20% return (and taxes consumed 22%), you really only had a 15.6% return after you paid Uncle Sam.

How to Use Losses to Your Gain

Realizing gains are inevitable in a portfolio. Unless you adhere very strictly to the “buy and hold” approach, your manager is most likely moving your assets around as he sees more attractive opportunities. As assets are sold, tax liabilities are created. So how can a manager be a good steward of this aspect of portfolio management? By what’s known as “harvesting losses.” The basic idea is this: if you own a stock that you want to continue owning, but is currently priced lower than what you paid for it, you can capture this loss and use it to your benefit. An example: Suppose you are a big believer that Michael Dell is going to right the ship and regain dominance in the PC industry in the future. So, you purchase 100 shares of DELL for a price of $30/share. After a few batteries explode, DELL shares drop to $25. You believe this is just the market overreacting to bad news, and have no intention of selling your shares and buying AAPL. But currently you have a $500 unrealized loss in your DELL shares. To harvest this loss, you simply sell your DELL, wait 31 days, then buy back 100 shares. Assuming the stock price doesn’t move dramatically in the interim, you’ve captured a $500 loss that can be used to offset other gains and still own the same number of shares you did before. There are some rules attached to regulate this strategy, the most important being the “wash rule.” The IRS says you have to wait 31 days on either side of a sell to buy shares back (or any loss is “washed” out). So, you could follow the strategy above, or you could buy 100 shares of DELL (at which point you would have 200 shares), wait 31 days and then sell the higher priced lot for a loss.

Mutual Funds

First, there are three ways that a mutual fund can generate a tax bill for you: by distributing 1) Dividends, 2) Income, and/or 3) Capital Gains. In the case of capital gains, what typically happens is as such: a mutual fund has a certain amount of realized gains at the end of the year, let’s assume it is $1 a share. Of this $1, assume $0.75 is from long term gains and $0.25 is from short term gains. The $1 is distributed to shareholders (the price of the mutual fund will decrease by $1 on the day that it happens), and the shareholder then pays the IRS according to their individual tax rates based on the amount they received. [So, (35% x $.25) + (15% x $.75) = $.20 paid in taxes on the $1.00 disbursement.]

The tax efficiency ratio is simply the after tax return divided by the pre tax return; the result is a figure that tells how much of a reported performance figure the investor actually kept (remember our example above where we broke out the tax bill). In a study of over 4800 mutual funds, the average tax efficiency ratio was 78%. Now, if you weed out all the specialty funds (i.e. real estate, fixed income, natural resource, etc.) we are left with a smaller universe of over 3,100 funds. Measuring this group of funds is more appropriate as it more closely resembles the strategy that we employ at SSA. From this group, the tax efficiency ratio is 88%. So, I think we can say with a high degree of confidence that the average mutual fund’s reported performance is reduced by taxes in the 10-12% range. In other words, if a fund reports that they had a 10% return in a particular year, we can estimate that only about 8.8%-9% actually went in the investor’s pocket (and stayed there). I try to collect “rules of thumb,” so I think a good one here is to say that when you read about a mutual fund’s performance, you can deduct about a tenth for taxes. Of course, that can vary wildly by fund, but one tenth seems about right.

It may be useful to examine a few actual funds to see how these numbers shake out. Below is a list of mutual funds that are managed by people we respect professionally both for their philosophical approach to investing as well as their track records. Included are figures on their funds’ tax efficiency as well as turnover.

So you can see that around 94% tax efficiency is where the cream of the crop sits. These funds also benefit from low portfolio turnover, and therefore longer holding periods, which mean less short term tax consequences. Turnover is basically the dollar amount of the portfolio that was traded during the last year; one way to interpret it is that the inverse of turnover is how many years the average stock is kept in the portfolio. So, the above funds average 17% turnover, or hold each investment in their portfolio for almost 6 years.

On the flip side, I found a few funds during the course of the study that were particularly tax inefficient. In some cases it was so bad that the fund showed a positive return, but the investor had to pay so much in taxes that they actually lost money. Below are a few funds that (although not so bad as the one I just mentioned) still lost a significant amount of their performance due to taxes.

Interpreting these figures, you see that over half the return was consumed by taxes for these funds. Remember, the numbers above represent the percent of the mutual fund’s reported return that investors kept. You’ll also notice that these funds all have over 100% turnover, meaning the manager bought and sold the entire portfolio (on a dollar amount) during the year. Doing such creates a large amount of short term capital gains, which are the highest taxed gains an investor can take.


Using the same procedure from above to calculate the tax efficiency of the average Smith, Salley & Associates account, we determine that our returns are 95.13% tax efficient. Our method was such: using a composite of 6 accounts that best represent the “Core Equity” strategy, we calculated long term gains, short term capital gains, and income generated and applied the appropriate tax amount. Then, we reduced the performance for the same period by the estimated tax bill. Using an average of these six accounts (which had a range from 91.75% - 99.75%) we came to the 95% figure. Comparing it to the “best of breed” mutual funds above, we are right on top of their averages.

In summary, one detrimental problem with many mutual funds is that they do not pay attention to the tax liabilities they create for shareholders. The reason is simple- very few other people look at this metric either. Many investors today at least pay attention to fees when scrutinizing performance, but very few examine tax efficiency. One of the advantages of a separately managed account is that we have the ability to harvest losses on an account by account basis to minimize a client’s tax bill. By our estimates, we do this 7% better than the average mutual fund; or our after-tax performance is 7% better than the average mutual fund that reports the exact same net of fees performance figure as us.

Taxes, fees, and excessive trading costs are all factors of investment management that can destroy long term capital appreciation for shareholders. They are not necessary evils though, and proper portfolio management can minimize their effect on investment returns. Performance is the great leveler in the investment world; when you are examining it though, make sure it is an apples to apples comparison. A mutual fund’s “return” is of little significance until you know how much you’ll have to “return” to the IRS.