Lipper Study Criticizes Tax-Inefficient Mutual Funds

Tax-News.com, New York

19 August 2002

A new study by Lipper, the New York-based fund research firm, Taxes in the Mutual Fund Industry, reveals that fund investors in high federal tax brackets needlessly give up several percentage points of return to taxes each year. Stock fund investors in the top tax bracket, according to the study, have given up an average of 2.5 percentage points to taxes each year, while bond fund investors have given up 1.3 percentage points on average each year over the past decade. These investors are losing nearly a quarter of their load-adjusted returns to taxes.

The study has been made possible by the new rule that mutual funds must publish details of their tax-adjusted returns. No doubt because such information has not historically been widely available, investors have shown surprisingly little appetite for tax-efficient alternatives: tax-managed funds, which explicitly aim to minimize taxable distributions, have managed to gather only 1.2% of fund assets held in taxable accounts, although the inclusion of pure index funds and municipal bond funds, which tend to be relatively tax-efficient, increases that proportion to about 25.7% of the fund assets held in taxable accounts.

"Tax-efficient funds have a huge opportunity to increase assets - both new assets that are currently in high-expense separate accounts and assets that are sitting in tax-inefficient funds," said the study's author, Lipper research analyst Tom Roseen. "Our report recommends that fund families and their boards put more emphasis on after-tax performance and create compensation packages that reward managers and advisers for minimizing the tax hit to their shareholders. As information on tax impact and after-tax performance becomes more widely available, sophisticated taxable shareholders will vote with their dollars."

Funds that invest in taxable bonds and carry a front-end 'load' (sales charge) offer an extreme example of the extent to which expenses, loads, and taxes can limit the returns that end up in an investor's pocket, says the report. Managers of these bond funds earned, on average, an annualized 5.81%, with total returns after expenses coming in at 4.71%. The load eats up nearly a fifth of the gross return. Taxes confiscate more than half of the gross return, because most of a typical bond fund's return is taxed as ordinary income, rather than at the lower capital gains rate. The taxable investor who held the fund would have netted just 0.81% per year after expenses, sales load, and the huge impact of taxes together consumed 86% of the fund manager's proceeds.

Some critics of tax-managed funds claim that portfolio managers will generate lower returns if they focus on minimizing the tax burden, but in several of the categories studied by Lipper, tax-efficient funds produced higher after-tax returns for investors than tax-inefficient funds that had higher total returns. This highlights the need for investors to become knowledgeable on how to interpret after-tax returns and how to use the simple tools that are available to identify tax-efficient funds.

"Taxable shareholders are still unaware that Uncle Sam takes a huge bite out of their wallets each year due to taxes on funds - a bite that is at least partly preventable," Rosen added. "Now, investors and advisers can access tools to create and review tax-efficient portfolios, taking into account all the drags on performance. But education by shareholder advocates is the first step."

Lipper, a wholly owned subsidiary of Reuters, is a leading global provider of mutual fund information and analysis to fund companies, financial intermediaries, and media organizations. Lipper clients manage more than 95% of U.S. fund assets. The firm, founded in 1973 and headquartered in New York, tracks 80,000 funds worldwide through its offices in major financial capitals in North America, Europe, and Asia.

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