A recent article in USA Today tried to explain why the returns investors receive are not the same as those advertised by mutual funds. The difference is often caused by sales loads and taxes on income and capital gains generated by the fund.
You can eliminate loads by buying a no-load fund or combining holdings within a fund family to reach the breakpoint at which loads are not charged. Lowering the tax hit is more difficult, unless your holdings are in a tax deferred account. Even then, taxes are deferred and not avoided. When you withdraw your funds, you will be subject to taxes at your marginal rate at the time.
Here’s the best way to get advertised returns or better: Purchase a globally diversified portfolio of low-cost index funds. In their often futile efforts to beat the markets, actively managed mutual funds (where the fund manager attempts to beat a designated benchmark) engage in high turnover of their portfolios. This excessive trading generates taxes and trading costs for mutual fund investors. In 2010, the turnover of the Schwab S&P 500 Index Fund was only 3 percent, compared to a turnover of 39 percent for the Fidelity Contrafund.
Actively managed funds incur other costs that reduce after-tax returns to investors. These include commissions, cash drag, transaction costs, and high expense ratios. The impact on investors of these costs is significant. The average equity fund had a return of 11.2 percent during the 15-year bull market from 1984 to 1998. That’s not bad until you consider the 15.8 percent return of market index funds during the same period.
The difference in returns before and after taxes between actively managed and index funds is striking. For the 25-year period from January 1980 to December 2005, $10,000 invested in the average actively managed equity fund would have grown to $108,347 pre-tax. The same investment in an S&P 500 index fund would have grown to $181,758. The difference in the after-tax returns is even more significant. The active fund investor ended up with $71,727 compared to a post-tax ending value of $158,975 for the index fund investor.
A study by Vanguard co-founder John Bogle found that over the period from 1984 to 1998, investors in actively managed funds kept only 47 percent of the cumulative returns of their funds. Investors in index funds kept 87 percent of their returns.
Index fund investors can reduce their tax hit even further by investing in a tax efficient or tax managed fund. Managers of these funds use tax savings strategies, like tax loss harvesting, to further reduce the already low impact of taxes on investors. Most active fund managers pay no attention to the after tax returns of their funds. They understand that investors focus on published, pre-tax returns and don’t calculate the impact of taxes.
While the financial media discusses loads and breakpoints, your focus should be on avoiding all actively managed funds and investing solely in index funds. You won’t have to worry about achieving the advertised returns of your funds. The after-tax returns of your portfolio are likely to significantly exceed those of a comparable, actively managed portfolio.
Dan Solin is a senior vice president of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, will be released in September, 2011.