How tax-efficient is your mutual fund? That is a question many investors wonder about, and they often assume that the easiest way to answer it is to look at the fund’s turnover. Investors often figure that high turnover means less tax efficiency, because more trading means more taxable capital gains.
But it isn’t that simple. A study of returns for dollar-denominated funds that I conducted with my research assistants found that turnover isn’t a reliable predictor of tax inefficiency for all funds. Indeed, we found that in the fixed-income sector, high-turnover funds are the most tax-efficient.
To examine this issue, my assistants Ricky Singh and Albert Valencia and I examined returns before and after taxes for all dollar-denominated mutual funds over the past 10 years. We divided that pool into index funds and actively managed funds in seven asset classes: U.S. large-cap equity, U.S. small-cap equity, international equity, U.S. value stocks, U.S. growth stocks, emerging-markets equity, and fixed income.
Next, we focused on the funds with the highest and lowest turnover in each group—those with turnover ratios at or above the 75th percentile and at or below the 25th percentile over the past 10 years. We then calculated the tax inefficiency of each fund as the annualized pretax return of the fund minus its annualized posttax return. The larger the number, the less efficient the fund.
Active funds
For actively managed funds, the turnover ratio does a pretty good job of identifying tax inefficiency.
For instance, the average high-turnover U.S. large-cap fund had an annualized pretax return of 12.20% and a posttax return of 9.73%—a difference of 2.47 percentage points. The average low-turnover U.S. large-cap fund had an annualized pretax return of 12.18% and a posttax return of 9.97%—a difference of 2.21 percentage points. The high-turnover funds were less efficient than the low-turnover funds.
That was true for five of the seven asset classes among actively managed funds. The only significant exception was for fixed-income funds. The average actively managed, high-turnover fixed-income fund had a tax inefficiency of 0.67 percentage point; the low-turnover counterparts were 0.94 point. The low-turnover funds were less efficient.
Index funds
Among index funds, turnover was a less reliable indicator of tax inefficiency than it was among actively managed funds. In five of the seven asset classes among index funds, the low-turnover funds were less efficient than the high-turnover funds. The biggest gap in favor of high-turnover funds was in fixed-income funds, where high-turnover funds had a tax inefficiency of 0.43 percentage point and low-turnover funds had an inefficiency of 0.80 percentage point.
All in all, our study shows that investors can’t simply rely on turnover ratios to determine the tax efficiency of mutual funds. For one thing, turnover figures don’t capture whether fund managers are selling short-term holdings or long-term holdings; long-term capital-gains tax rates are lower than short-term tax rates. Also, fund managers all have their own methods to reduce tax bills.
Investors can read about a fund’s tax-management strategies in its annual report. But the simplest way to determine the tax efficiency of a fund is to compare its pretax and posttax returns as we did in our study.
The Wall Street Journal
By Derek Horstmeyer
Dr. Horstmeyer is a professor of finance at George Mason University’s Business School in Fairfax, Va. He can be reached at reports@wsj.com.
Dow Jones & Company, Inc.
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