Is Your Tax-Efficient Fund Ripping You Off?

Last Updated Mar 31, 2010 9:09 PM EDT

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A few weeks ago, I wrote about the importance of considering a fund's tax-efficiency when selecting an investment. And while it's true that choosing a fund that minimizes your tax bill is a wise strategy, investors need to use a discerning eye in doing so, because it's possible for a fund to be tax-efficient for all the wrong reasons.

To illustrate this point, I took a look at all of Morningstar's large-cap funds, and sorted them into quartiles by their three-, five-, and ten-year tax cost ratio -- which is Morningstar's estimate of each fund's annual tax bill, and, like an expense ratio, is expressed as a percentage of the fund's assets. The results are in the table below.

Quartile

Average tax cost ratio

Average expense ratio

Three years

Lowest tax bill

0.15%

1.27%

Highest tax bill

1.64%

0.94%

Five years

Lowest tax bill

0.13%

1.24%

Highest tax bill

1.61%

0.96%

Ten years

Lowest tax bill

0.22%

1.24%

Highest tax bill

1.43%

0.92%

The pattern is striking. In each period, the funds with the lowest tax bill were also the most expensive. Likewise, in all but the three-year period, the least tax-efficient funds had the lowest average expense ratio. (In the three-year period, the lowest-cost quartile was the third, with an average expense ratio of 0.92 percent.)

The reason for this is quite simple: Equity funds use the dividends produced by their holdings to pay their expenses, and any amount left over is passed along to the fund's shareholders.

Thus, an expensive fund gobbles up most -- if not all -- of the dividends that its portfolio throws off, minimizing the dividends passed through to its investors. Doing so, of course, produces what appears to be a wonderful tax cost ratio. But all things equal, the fund's shareholders would be far better off if they sacrificed a bit of tax efficiency in exchange for keeping more of the income their investment produced.

A quick example shows just how this works. Consider the records of two S&P 500 index funds, Morgan Stanley's S&P 500 Index fund and Fidelity's Spartan 500 Index fund. The former is quite expensive, with an expense ratio of 0.59 percent for the A-class shares. Fidelity's fund, on the other hand, has a rock-bottom expense ratio of 0.1 percent.

In its most recent annual report, we learn that Morgan Stanley's fund earned $14.7 million of investment income, and had total expenses of $4.7 million. The fund's expenses consumed 31 percent of its dividend income, leaving its shareholders with just 69 percent.

Fidelity's fund, meanwhile, produced $562 million of investment income, and its total expenses were just $21 million. Thus, the Fidelity fund investors got to keep 96 percent of the dividend income their fund produced.

That staggering difference explains why the Morgan Stanley fund's tax cost ratio is so much lower than the Fidelity fund's (0.41 percent versus 0.62 percent, respectively, over the past ten years).

So yes, investors should by all means consider a fund's tax-efficiency. But in doing so, dig a little deeper, and make sure that the fund has earned its tax-efficiency stripes the right way, and not by siphoning off an inordinate share of the dividends that rightly belong to the fund's investors.

More Tax Tips:
New Tax Credits for Home Improvement
Best Uses for Your Tax Refund
Audit Red Flags
Be Prepared for Higher Taxes
Roth IRAs: Should you Convert?
  • Nathan Hale

    View all articles by Nathan Hale on CBS MoneyWatch »
    Nathan Hale has spent decades working in the financial services industry, during which he has researched and written extensively about personal investing, the mutual fund industry, and financial services. In this role, he uses a nom de plume because many of his opinions about the mutual fund industry and its practices would not endear him to its participants.

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