In this month's Research Perspective, I'm going to talk about everyone's favorite topic; taxes. Okay, taxes are probably not your favorite topic, but if you are investing in mutual funds in a taxable account, they are very important to keep in mind.

Unfortunately, what investors have in mind with respect to taxes and mutual funds is too often more myth than reality. (Not surprisingly, many of these myths are promulgated by those who sell individual securities rather than mutual funds!)

Please bear with me and let's quickly review the definitions of some key tax terms to make sure we have our bearings. It will be important when I start to attack some of leading myths in the industry about investing in taxable portfolios.

• Unrealized loss: When the current market value of a position in an investment account is lower than its cost basis. Nobody likes a losing position, but in investing they are inevitable.

• Realized loss: When an investment position with an unrealized loss is sold (or closed out) you now have a realized loss. Realized losses have economic value, as they can be used to offset future realized investment gains. This action is also referred to as “taking a tax loss.”

• “Harvesting” tax credits: Another term for taking tax losses, this phrase stresses the positive economic value of taking such action.

• Tax swaps: A tax swap is replacing a market exposure (position) in a portfolio with a similar (but not identical) market exposure to harvest a tax loss.

• Tax-loss carryforward: When realized losses exceed realized gains in a given year, those excess tax-losses can be used to offset realized gains in future years – or “carried forward.” Tax-loss carryforwards are assets, and should be treated accordingly. (Note: you can generate excess tax losses even if your portfolio had a significant overall gain for the year).

• Potential capital gains exposure: This figure attempts to describe how vulnerable a mutual fund may be to future capital gains distributions. It is calculated by combining any tax-loss carryforwards, with both realized and unrealized gains and losses. (Note: Morningstar does a fine job attempting to compile this information on a continuous basis).

• Pre-tax return: The return on an investment portfolio, before the effect of any taxes. For tax-deferred portfolios (such as IRA’s), maximizing the pre-tax return, given the appropriate level of risk, is our goal.

• After-tax return: The return on an investment portfolio, after taxes are subtracted. (When we look at mutual funds, we take the conservative route and always assume the highest tax rates). For taxable portfolios, maximizing the after-tax return, given the appropriate level of risk, is our goal.

• Tax costs: This is the difference between the pre-tax and after-tax return. For example, a fund with a 3% tax cost ratio would see its pre-tax return of 10% reduced to a 7% after-tax return. This is another cost to monitor just like a fund’s expense ratio. In fact, for taxable investors, tax costs will likely have a more significant impact on returns than expense ratios. A recent study by Lipper found that, over the last ten years, on average, taxes were the largest drag on performance for taxable investors. The average tax cost for equity funds has been around 1.8%, while the average expense ratio has been about 1.5%. (Note: the average tax cost for taxable fixed income funds over the last 10 years is 2.5%).

• Tax efficiency: A general phrase to describe how efficient an investment is at retaining its pre-tax return. The precise definition is the ratio of pre-tax return to after-tax return (pre-tax return divided by after-tax return). While this is a useful ratio to monitor, we feel that it can be potentially misleading. In our taxable portfolios we are looking for funds that we feel will generate the highest after-tax returns, not necessarily the highest rates of tax efficiency. The difference is important.

• Income distributions: This is one of three ways that clients can experience a taxable event with a mutual fund. A distribution is a scheduled pay-out from a mutual fund, much like a dividend is from a stock or an interest payment from a bond. In the case of an income distribution, generally speaking, this is where the fund passes on any dividends or interests (less expenses) from its underlying holdings. Income distributions are taxed at 15% on qualified dividend income (it used to be the highest marginal tax rate) and at the highest marginal tax rate (35% maximum) for non-qualified dividend income and interest income.

• Capital gain distributions: Capital gain distributions occur when mutual funds pass on their realized gains (less unrealized losses) that they accrue over the preceding fiscal year as required by law. Long-term capital gains are taxed at 15% (it used to be 20%). Short-term gains, however, are still taxed at the highest marginal tax rate (35% maximum).

• Sale of Fund: The third way a shareholder can experience a taxable event is when they sell a fund that has an over-all gain. Of course, if a shareholder sells a fund with a loss, they are able to harvest a tax credit.

Now on to the myths...

Myth #1: Taxable Investors Should Simply Not Use Mutual Funds
This is probably the biggest myth of all. The claim often advanced is that mutual funds are not tax efficient, while individual securities are. But the claim is specious. It is based on comparing an investor buying-and-holding a single mutual fund, to an investor owning an actively managed portfolio of individual securities where somebody can pro-actively match up tax losses with investment gains to reduce taxes. That is simply apples to oranges.

The fair comparison would be an actively managed portfolio of mutual funds to an actively managed portfolio of individual securities. Under that scenario, mutual funds offer the investor the same opportunities to actively match up tax losses with gains and thereby reduce taxes.

To be fair, given that individual securities have more volatility than individual mutual funds, a portfolio of individual securities will typically generate more frequent opportunities to harvest losses, but nonetheless, a portfolio of mutual funds can still be managed in a reasonably tax efficient manner.

In addition to using tax swaps to harvest unrealized losses all year long (not just in December!), there are many techniques that a tax-aware investor can use with a mutual fund portfolio to reduce the impact of taxes. Some of these tactics include identifying tax efficient funds, managing around mutual fund distributions and staying alert to short-term and long-term holding periods.

In fact, some mutual funds come with built-in tax efficiency! Buying a fund that has a significant tax-loss carryforward on its books means that you have protection against capital gains distributions (and associated taxes) until that carryforward is used up.

Lastly, remember that a portfolio of individual securities, even if there are no trades, can still generate taxable events, either through regular dividends or even through mergers and acquisition activity.

Myth #2: Funds With Lower Turnover Are More Tax Efficient
Virtually everybody in the industry mentions this “fact.” But while a quick snapshot will indeed show a correlation between lower turnover and higher tax efficiency, turnover is actually not one of the top predicators of future tax efficiency and should not be the only factor relied upon.

High turnover does mean more “taxable events,” but not necessarily more taxes. People often equate high turnover with higher taxes because they only think about funds selling to take a gain. But what about a fund that actively sells to harvest tax losses, and thus has higher turnover as a result? They are actually reducing taxes!

The most important factor is whether or not the manager cares about tax efficiency. This can be determined by examining the firm’s stated policy, whether the manager has a significant personal stake in the fund, and their compensation incentives.

If the manager is indeed tax aware, it usually shows up in the fund’s after-tax returns. Looking at historical tax cost and tax efficiency ratios is also important to monitor. Funds that are historically tax efficient tend to be relatively tax efficient moving forward – assuming there is no change in the fund’s people, philosophy or process.

Another crucial statistic to monitor is the level of cash flows in or out of a fund. A fund with heavy inflows will basically dilute any distributions, while one experiencing large cash outflows will see any distributions magnified.

For example, lets take a fund that starts the year with $200 million in assets and during the year realizes $10 million in gains that they have to distribute to shareholders as a capital gain at the year-end. If the fund had no asset growth at all, the distribution would be 5% (10/200). However, if assets had grown to $400 million by the end of the year, the distribution would be only 2.5% (10/400). On the other hand, if assets had shrunk to $100 million, the distribution would grow to 10% (10/100). This is one advantage of a fund growing its asset base.

Other key factors to monitor include the potential capital gains exposure (including any tax-loss carryforwards, realized gains and losses, and unrealized gains and losses), the inherent tax efficiency of the investment securities the fund actually invests in, and whether or not there has been a managerial change or a change in the investment process

It is also important to maintain regular communication with the mutual funds to know as quickly as possible the potential size and timing of distributions. This can be critical as it can impact portfolio decisions.

A couple of last notes on how to shop for tax efficient funds:

First, many tax efficient funds are only tax efficient because they aren’t any good at generating gains! Second, the statistic that actually correlates the best with after-tax returns is pre-tax returns. Both of these points relate to the cliché “don’t let the tax tail wag the dog”. While obviously we care about taxes and maximizing after-tax returns, we realize that tax considerations should be secondary to generating superior pre-tax returns in the first place.

Myth #3: Tax Inefficient Funds Should Not Be Used in Taxable Accounts
Many firms in the industry take the easy road and simply use the funds that they view are the most tax efficient in taxable accounts. This may sound great, but it’s not really the goal of investing taxable portfolios. As we noted earlier, maximizing the after-tax return, given an appropriate level of risk, should be the goal for a taxable portfolio.

To take just one example, many taxable portfolios will not use taxable high-yield bond funds. Indeed, high-yield bond funds are generally very tax inefficient. Yet, if valuations or fundamentals (or both) are extremely attractive for high-yield bonds relative to (tax-free) municipal bonds, the potential for a much higher pre-tax return on high-yield makes it very reasonable to expect a higher after-tax return (versus munis) as well. In addition, high-yield bond funds can offer outstanding diversification benefits to a portfolio, above and beyond what municipal bond funds typically provide.

Automatically excluding tax-inefficient funds from taxable accounts is simply lazy portfolio management. Over time this may compromise the ability to generate superior after-tax risk-adjusted performance.

Myth #4: Taxable And Tax-Deferred Portfolios Should Have Similar Pre-Tax Returns
Many clients compare the pre-tax returns on their taxable portfolio to the pre-tax returns on their retirement portfolio. This is a false comparison. All things being equal, a taxable portfolio is likely to have lower pre-tax returns than a tax-deferred portfolio.

Remember, in a taxable portfolio we are managing to maximize after-tax returns, so we often use tax-exempt securities, as municipal bonds. Normally, municipal bonds will offer lower yields than a comparable taxable bond and thus generate a lower pre-tax return for the portfolio.

Let’s take a simple example using just one position for an investor in the 35% federal income tax bracket:

	Holding	Duration	Yield	Pre-Tax Return
Taxable Portfolio	Fidelity Spartan Intermediate Muni	5.3 yrs	3.31%	3.31%
Tax-Deferred Portfolio	Vanguard Intermediate Treasury	5.0 yrs	4.01%	4.01%

Considering just federal taxes for simplicity, the after-tax return on the taxable portfolio will still be 3.31% because muni bond interest is exempt from federal taxes.

You can’t easily compare the after-tax returns on the two portfolios since there are no taxes due on the tax-deferred portfolio until you begin to take distributions at a later date.

However, you can easily demonstrate the after-tax benefit of owning the Fidelity Muni fund in a taxable account. If you owned the taxable Vanguard fund instead, its higher pre-tax return of 4.01% would be reduced to a 2.61% after-tax return (4.01% less 35% in taxes) compared to 3.31% after-tax for the muni option.

Myth #5: Taxes Should Only Be A Consideration In December
As you might have guessed from when we decided to publish this article, smart tax management of your portfolio is something we employ continuously, not just toward the end of the year.