Last Updated Mar 5, 2010 4:46 PM EST
Most experienced investors are aware of the importance of minimizing expenses. Historical data clearly show that paying below-average expenses is the surest route to earning above-average returns. But what many mutual fund investors overlook is the importance of maximizing tax-efficiency.
Yes, many investors own mutual funds in tax-deferred retirement accounts, in which concerns about tax-efficiency are moot. But according to data from the Investment Company Institute, 53 percent of all stock and bond fund assets -- and 67 percent of all fund assets -- are held outside of retirement accounts. Yet despite this fact, there is little evidence that mutual funds are chosen with much concern for the negative impact that taxes can have on their overall return.
Of course, taxes are part and parcel of investing. We'll almost surely owe taxes eventually on any gains that we earn. But the inevitability of a tax bill doesn't mean that fund investors should ignore the importance of minimizing the taxes they incur along the way; deferring that tax bill for as long as possible amounts to an interest-free loan from the federal government.
According to Morningstar, the average domestic equity fund has earned an average annual pre-tax return of 7.9 percent over the past 15 years. At that rate, an initial investment of $10,000 would have grown by $21,100. On an after-tax basis, the average fund's return was 6.2 percent. (This is what Morningstar calls the "pre-liquidation" after-tax return, which accounts only for taxes paid on the funds' annual distributions, and not taxes due on gains realized upon the fund's sale.) At that rate, $10,000 would have grown by $14,700, meaning that 30 percent of the total growth would have been sliced off by taxes along the way.
To demonstrate the importance of tax-efficiency, consider how a strategy that focuses on minimizing taxes compares to one focused on minimizing expenses.
Over the past 15 years, the lowest-cost quartile of domestic equity funds earned 8.1 percent annually, slightly outpacing both the three higher-cost quartiles, and the overall average of 7.9 percent. On an after tax basis, the low-cost quartile's margin widened a bit, to 0.3 percent (6.5 percent for the low-cost funds, versus 6.2 percent for all funds). Investors were clearly rewarded for minimizing their annual expenses.
But what if, instead of expenses, our investor focused on minimizing their annual tax bill? A fine way of doing so would be to sort the funds by their annual turnover rate, which measures how frequently the fund is trading the stocks in its portfolio. A turnover rate of 100 percent, for instance (which is about the industry average), indicates that the fund's holdings are held for one year on average.
Obviously, if a fund is turning over the stocks in its portfolio that frequently, it is also likely realizing capital gains, which are passed along to the fund's shareholders each year.
Like our low-cost investor, an investor who chose the lowest-turnover quartile of funds prevails over the average by the same margin (8.1 percent to 7.9 percent). But on an after-tax basis, the low-turnover quartile's winning margin improves to 0.6 percent (6.8 percent to 6.2 percent for all funds), offering proof that low-turnover funds are indeed more tax-efficient.
So if keeping costs low helps boost your pre-tax return, and keeping turnover low boosts your after-tax return, what do you suppose happens when you limit your search to funds that offer both low costs and low turnover?
As it turns out, 86 funds over the past 15 years reside in both the low-cost and low-turnover quartiles, and this group's pre-tax return (8.4 percent) and post-tax return (7.1 percent) far outpace both the overall average, and the heretofore superior returns achieved by the lowest-cost and lowest-turnover quartiles.
But here's the most interesting point. Of those 86 funds, 47 -- or 55 percent -- are index funds. The record of one of those funds, Vanguard's Total Stock Market Index, nicely encapsulates the tremendous tax advantages that an indexing approach offers. The fund's 15-year pre-tax return of 7.6 percent was fairly pedestrian compared to the records of the funds that survived the period. But its after-tax return of 7 percent vaulted it into the top third of all equity funds for the period. And as time marches on, the fund's relative return will almost doubtlessly improve.
The moral? Costs are important. But so is tax-efficiency. A strategy of minimizing costs and maximizing tax-efficiency gives investors a tremendous leg up in their search for above-average performance over the long-term, and wisely implementing such a strategy will almost invariably rely heavily on index funds.