Investors often try to save costs on their mutual fund investments by choosing those with no initial loads. Others select funds with relatively low administration fees, hoping more of their money will go to work for them. But they could be missing out on what could be the biggest benefit of all — funds that help them save on taxes.
The Securities and Exchange Commission estimated in a Jan. 18, 2001, ruling that more than 2.5 percentage points of the average stock fund's total return is lost each year to taxes. As a result, investors who believe they are enjoying an annual return of 10 percent on a fund might discover on closer examination that the earnings are reduced to 7.5 percent a year, or less, after taxes.
Given the events in the market over the last two years, funds designed to be managed tax efficiently could be more suitable for many of your clients — and prove more popular — than ever.
Two major factors make tax efficiency a hot button for clients:
Information reporting requirements, that were set to take effect last month, call for mutual fund companies to specify the typical tax costs of an investment over certain periods of time.
Clients either will have suffered themselves from paying high capital gains taxes during 2001 on their 2000 tax filings or have heard of others who did so and want to avoid a similar fate.
While capital gains were expected to be much lower in 2001 than a year earlier, tax considerations should still be a strong motivator in planning portfolios for 2002.
In 2000, many funds distributed capital gains as great as 20 percent, but some were as high as 62 percent. And only 65 percent of long-term investments in mutual funds are in tax-deferred accounts, leaving 35 percent that are taxed, according to a February 2001 report published by the Investment Company Institute (ICI), the mutual fund industry trade association. Mutual funds distributed an estimated $345 billion in capital gains in 2000, according to the association's February report. That's sharply higher than the $238 billion distributed a year earlier, according to a May 2000 ICI report.
Investors without adequate resources may have been forced to sell some of their investments to pony up the tax. Those who sold their mutual fund shares close to the deadline for tax payments, April 15, did so at some of the lowest levels on the market for more than two years up to that time, intensifying the damage to their portfolios.
Taxable income from mutual funds can result from the payment of dividends, which are passed on to investors. But the bulk comes from the distribution of capital gains, incurred when fund managers sell stocks at a profit. If the profit is not offset by capital losses — resulting from sales of stocks at a loss — the law requires that the gains be distributed to investors, who have to declare them as short- or long-term capital gains on their tax returns.
More of your clients also could be drawn to tax-advantaged funds when they realize that they do not always have to lose out on performance. A Frank Russell comparison indicates that tax-managed funds generally have returned results that are comparable with the Standard & Poor's 500 index net of the taxes that are incurred by the distribution of dividends.
Tax-managed funds also come in a variety of flavors to suit investment objectives.
Investors might not quibble at paying a 1 percent fee, therefore, when they are saving 3 percentage points or even more in after-tax returns through a tax-managed fund. They will realize that their investments are being handled by a manager whose goal is to meet the investment objective, but will be tax savvy in managing the fund.
Such a manager will decide to sell losing securities more quickly than otherwise might be the case and seek to reinvest as soon as possible in quality stocks at lower prices. Using the High Cost First Out system of accounting, the manager can pick the stock lot that costs the most and sell it first when the market turns down, reducing the amount of profit that is subject to capital gains.
These managers handle the funds as investors themselves would if they were aware of all the factors and were they faced with the same opportunities.
Investors should not really be concerned about the normal performance numbers, but with what they add to their pockets at the end of the day. Investing in tax-managed funds could significantly increase the final take-away amount.
Chief Investment Officer of Frank Russell Co.