With 2021 just a few weeks from its end, tax season will soon be upon us. Last month I offered some suggestions for a year-end portfolio review, and one of the topics was attending to year-end tax matters.
If you invest in mutual funds—whether you are just starting out or are looking to make changes to your portfolio—understanding a fund’s tax efficiency could save you money in the long run.
In this installment of Making the Grade, we examine how you can use A+ Investor to gauge the tax-friendliness of a mutual fund.
When it comes to investing in mutual funds versus individual stocks, fund investors are at a disadvantage regarding taxes.
Stock investors pay taxes on investments only if they have pocketed dividends or income or have sold stocks for a profit. This means stock investors have a significant level of control over when they have to pay taxes.
But investors of traditional mutual funds can face a tax bill even if they haven’t sold any of their holdings or even if they’ve lost money since investing in the fund.
Like all investors, mutual fund holders have to pay taxes on dividends from stocks and interest from bonds. However, they also have to pay taxes on fund distributions. Mutual funds are required by law to make regular capital gains distributions to their shareholders. The owners of mutual fund shares can take the capital gains distribution in the form of immediate payments or reinvest it in additional fund shares.
A distribution generally refers to the disbursement of assets from a fund to an investor. Mutual fund distributions typically consist of net capital gains made from the profitable sale of portfolio assets and dividend income and interest earned by those assets. Mutual funds tend to be tax-inefficient from the standpoint that investors do not have control of when a fund manager sells portfolio assets.
There is also a difference in tax treatment between open-ended mutual funds and exchange-traded funds (ETFs). ETFs can be more tax-efficient compared to traditional mutual funds. Generally, holding an ETF in a taxable account will generate less tax liabilities than if you owned a similarly structured mutual fund in the same account.
From the perspective of the IRS, the tax treatment of ETFs and mutual funds are the same. Both are subject to capital gains tax and taxation of dividend income. However, ETFs are structured so that taxes are minimized for the holder of the ETF, and the ultimate tax bill—after the ETF is sold and capital gains tax is incurred—is less than what the investor would have paid with a similarly structured mutual fund.
There are fewer “taxable events” in a conventional ETF structure than in a mutual fund. Here’s why:
A mutual fund manager must constantly rebalance the fund by selling securities to accommodate shareholder redemptions or reallocate assets. The sale of securities within the mutual fund portfolio creates capital gains for the shareholders, even for shareholders who may have an unrealized loss on the overall mutual fund investment.
In contrast, an ETF manager accommodates investment inflows and outflows by creating or redeeming “creation units,” which are baskets of assets that approximate the entirety of the ETF investment exposure. As a result, the investor usually is not exposed to capital gains on any individual security in the underlying structure.
However, it’s worth pointing out that mutual fund managers take advantage of carrying over capital losses from prior years, tax-loss harvesting and other tax mitigation strategies to diminish the impact of annual capital gains taxes.
Also, index mutual funds are far more tax-efficient than actively managed funds because of lower turnover.
So, how can you gauge the impact of taxes on your fund holdings? First, high turnover can signal that a find may not be tax-efficient.
Using the A+ Investor Funds+ Screener, we isolated those non-index U.S. sector equity funds that track the technology sector. We also excluded institutional funds and other “non-investor” funds and those that are not open to new investors. Lastly, we looked for those technology funds with turnover ratios below their category average and not charging a load (no-load funds). As of November 30, 2021, 13 funds in the A+ Investor universe match these criteria.
A mutual fund with a high turnover rate increases its costs to its investors. Furthermore, higher turnover rates can also have adverse tax consequences. Funds with higher turnover rates are more likely to incur capital gains taxes, which are then distributed to investors. As a result, investors may have to pay taxes on those capital gains.
Among these 13 funds, the annual portfolio turnover ranges from 4% for the Red Oak Technology Select fund 
(ROGSX) to 65.9% for the T. Rowe Price Science & Technology fund (PRCSX).
The Fund Evaluator available to all A+ Investor subscribers provides portfolio turnover information on the fund’s overview page, as shown below.
Another useful metric is the tax-cost ratio, which measures how much investors’ taxes on distributions reduce a fund’s annualized return. For example, mutual funds regularly distribute stock dividends, bond dividends and capital gains to their shareholders. Investors then must pay taxes on those distributions during the year they were received.
Think of the tax-cost ratio as you would an expense ratio. Like an expense ratio, the tax-cost ratio measures how one factor can negatively impact performance. The lower the tax-cost ratio, the lower the tax impact if you hold the fund in a taxable account. Like an expense ratio, it is usually concentrated in the range of 0% to 5%. Zero percent indicates that the fund had no taxable distributions, and 5% means that it was less tax-efficient.
For example, if a fund had a 2% tax-cost ratio over the past three years, it means that each year, on average, investors in that fund lost 2% of their assets to taxes. If the fund had a three-year annualized pretax return of 10%, an investor took home about 8% on an aftertax basis.
Among the 13 funds from the example above, the TCW Artificial Intelligence Equity fund (TGJNX) and the Firsthand Alternative Energy fund (ALTEX) have tax-cost ratios of 0.0% [the Eventide Exponential Technologies fund (ETNEX) does not have a reported tax-cost ratio]. In contrast, T. Rowe Price Science & Technology has a three-year tax-cost ratio of 4.3% (its annual portfolio turnover is 55.9%).
Tax-cost ratio data is also provided on the Fund Evaluator overview page for any fund, as shown below.
We do not believe that taxes should not be the tail that wags the portfolio dog. In other words, you shouldn’t automatically buy a fund because its tax-cost ratio is low or zero (or avoid funds with relatively high tax-cost ratios). Many good funds pay out distributions, so you shouldn’t necessarily avoid a fund because it has a greater than 0% tax-cost ratio. However, you may wish to hold funds with high tax-cost ratios in nontaxable accounts, such as 401(k)s and IRAs.
