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Much attention has been paid to expense ratios of mutual funds. Yet, despite the fact that taxes have a substantial impact on the long-term performance of taxable mutual fund investors, far less attention has been paid to the impact of taxes on after-tax returns. And while the evidence is clear that it's difficult for active fund managers to create superior investment performance by picking stocks or by timing markets, it's relatively easy to avoid destroying value for taxable fund investors by managing investment taxes. For example, tax-aware funds might attempt to reduce the tax burden by avoiding the intentional realization of any short-term gains and by accelerating the realization of capital losses. Tax management strategies might not only reduce the tax burden, they might also generate lower trading costs. For example, tax-efficient investment strategies exhibit relatively low turnover, generating lower trading costs. In addition, liquidating stock positions with embedded capital losses and holding on to positions with capital gains might generate superior before-tax returns due to the momentum effect.

Clemens Sialm and Hanjiang Zhang, authors of the 2013 study "Tax Efficient Asset Management: Evidence from Equity Mutual Funds," investigated the costs and benefits of tax-efficient asset management on U.S. equity mutual funds for the period 1990-2012. The following is a summary of their findings:

  • On average, taxable fund shareholders are estimated to pay investment taxes of 1.12 percent value per year, similar in size to the average expense of a fund.
  • The standard deviation of the annual tax burden is 1.58 percent, more than three times the standard deviation for expenses.
  • Large cross-sectional differences in tax burdens can have substantial impact on investment performance.
  • Mutual funds that follow tax-efficient strategies generate superior after-tax returns.
  • Passively-managed funds tend to exhibit lower tax burdens than actively-managed funds, despite their higher dividend yields.
  • Tax burdens are especially low for exchange-traded funds, which exhibit very low capital gains distributions.
  • There's no evidence that high tax burden funds exhibit superior selectivity or timing abilities.
  • Tax burdens are highly persistent - funds in the highest tax burden group continue to exhibit significantly higher tax burdens than funds in the lowest tax burden group until five years after the portfolio formation.
  • Tax burdens on mutual funds tend to be higher for funds that focus on small-cap and value stocks, as these investment styles trigger relatively higher capital gains distributions as a result of stocks that perform well exiting their asset class. The tax cost for small-cap funds was 1.43 percent versus 1.28 percent for large-cap funds. For value and growth funds, the tax costs were 1.53 percent and 1.25 percent, respectively.
  • Momentum funds that hold stocks with superior recent stock market performance also exhibit higher tax burdens.
  • Tax burdens also increase with the turnover, the age, and the capital gains overhang of the fund.
  • Funds that experience negative or volatile new money growth over the prior year tend to distribute higher capital gains over the subsequent year, since these funds are more likely to sell shares and recognize capital gains.
  • There's a strong inverse relation between prior tax burdens and subsequent after-tax performance regardless of the time horizon and the performance measures. For example, funds with the lowest tax burdens during the prior three years underperform the market by 0.19 percent per year after taxes. On the other hand, funds with the highest tax burdens during the prior three years underperform the market by 2.29 percent after tax. The difference in after-tax performance of 2.10 percent is statistically and economically highly significant.

The authors concluded: "Due to the persistence of the tax burden, fund investors can increase their future after-tax performance by avoiding funds with high prior tax burdens." They found that funds in the lowest tax burden quintile over the previous three years exhibit excess returns of -0.19 percent over the subsequent year after taxes, whereas funds in the highest tax burden quintile exhibit excess returns of -2.29 percent after taxes.

The authors also found that mutual funds that generate lower taxable distributions don't underperform other funds before taxes, indicating that the constraints imposed by tax-efficient asset management don't have significant performance consequences.

To highlight the impact of taxes on after-tax returns, the authors selected two growth funds with extreme average tax burdens over the period 1990-2012. The tax-efficient fund had an average tax burden of 0.44 percent per year, while the tax-inefficient fund has an average tax burden of 3.77 percent per year. The average before-tax returns were similar: 12.35 percent per year for the tax-efficient fund and 13.13 percent per year for the tax-inefficient fund. However, the distributions of the funds differed significantly. The tax-efficient fund distributed primarily dividends, while the tax-inefficient fund distributed a significant proportion of short-term capital gains. A one-dollar tax-exempt investment in the two funds at the beginning of 1990 would have accumulated in December 2012 to $10.05 for the tax-efficient fund and to $10.82 for the tax-inefficient fund. However, a one-dollar investment would have increased after taxes to $9.12 for the tax-efficient fund and to just $4.08 for the tax-inefficient fund. Thus, the accumulative value of the high-tax fund is less than half the accumulative value of the low-tax fund over this 23-year investment horizon. The difference in the accumulative account values shrinks slightly if liquidation at the end of the period occurred. Since the tax-efficient fund had an embedded capital gain and the tax-inefficient fund had an embedded capital loss, the liquidation tax reduced the value of the tax-efficient investment from $9.12 to $7.74 and increased the value of the tax-inefficient investment from $4.08 to $5.35. The tax-efficient fund produced 45 percent greater ending value.

The authors concluded: "We find that taxes have a significant impact on the performance of taxable fund investors." If you haven't been paying attention to tax efficiency, perhaps the evidence presented here will act as a wake-up call. You can improve your tax efficiency (and after-tax returns) by moving from active to passive strategies. And if you're already using passively managed funds, you can move from non-tax managed funds to tax-managed versions or using ETFs.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Start Paying Attention To Tax Efficiency