Posted on Tue, Nov. 28, 2006
COMMENTARY | Tax-inefficient mutual funds
It’s time for revolt
By RICHARD D. ROMEY, ETF Portfolio
Solutions, Inc.
Guest Columnist
In
1773, a group of brave Bostonians dumped tea into Boston Harbor to protest
taxation without representation. They risked life and limb to fight unfair and
excessive taxation.
Despite their actions, millions of investors today calmly sip their tea (or
coffee), read their mutual fund reports and quietly accept excessive taxation
each year and never give it a second thought.
According to the Investment Company Institute, a mutual fund industry research
firm, U.S. mutual fund investors could pay more than $20 billion in taxes this
year because of capital gains distributions by funds. Unlike other investments,
a mutual fund is a pass-through investment vehicle. All earnings — capital gains
and dividends — must be distributed to the shareholder. The shareholder is
responsible for paying taxes on the earnings, whether they’re reinvesting those
earnings or not.
Mutual fund capital gains distributions are expected to exceed $200 billion this
year, making 2006 the third-highest year for distributions, surpassed only by
$238 billion in 1999 and $326 billion in 2000.
What does this mean to you? If you own a mutual fund in a taxable account, your
after-tax return may be substantially less than you think. Some experts suggest
that the average investor loses more than 2 percentage points a year to taxes.
For example, if you own a mutual fund in a taxable account that averaged 7
percent a year in the last five years, your return after taxes may only be 5
percent a year.
The reason mutual funds tend to be so tax inefficient is that fund managers have
no incentive to limit capital gains. They’re interested in performance at any
cost. If that means selling securities and realizing huge capital gains, so be
it. After all, they’re not the ones paying the taxes, you are. Even if you buy
shares of a mutual fund after the fund has realized a gain but before the gain
is paid, you’re still liable for the taxes.
Mutual fund capital gains distributions can be a problem even in years when the
market is down. In 2000, when the market registered substantial losses, many
long-term mutual fund investors took a double beating. They lost money as the
price per share of their mutual funds dropped and had to pay taxes on gains
generated in the fund’s portfolio. What a great investment: lose money and pay
taxes.
What can investors do to minimize their potential tax liability? The best way is
to use a more tax efficient investment product, such as exchange-traded funds
(ETFs). An ETF is essentially a basket of securities that can be bought or sold
on an exchange, like shares of stocks. Like index mutual funds, ETFs are
designed to track a specific market index or benchmark. Unlike mutual funds,
ETFs are bought or sold on an exchange during regular market hours.
The unique way ETFs are structured makes them very tax efficient. This was
evident in December 2005, when the largest family of ETFs (the iShares)
announced for the fourth consecutive year zero year-end capital gains
distributions for all 101 iShares. Mutual funds passed through record levels of
taxable capital gains in this same period. ETF investors paid less in taxes and
kept more of what they earned.
Send a message to the mutual fund industry and move your money to tax efficient
exchange-traded funds.
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Richard Romey is author of “Strategic Index Investing – Unlocking the Power of
Exchange-Traded Index Funds” and president of Romey Capital Management Inc.
(now named ETF Portfolio Solutions, Inc.)
Comments or questions about this article can be sent to [email protected] or
call (913) 647-5220.
