Mutual fund turnover
The tax bill for your mutual
fund can be an unpleasant surprise. Unlike owning individual securities, where
you pay a capital gains tax when you sell shares, with a mutual fund you may owe
Uncle Sam even if you don't sell any shares.
When a mutual fund
portfolio manager sells shares within the fund, it can trigger a capital gains
distribution -- that means a tax bill for you. For the most part, it's a good
idea to steer clear of funds that rack up big tax bills while you hold the shares.
Securities and Exchange Commission says more than 2.5 percent of the average stock
fund's total return is lost each year to taxes, significantly more than the amount
lost to fees. The tax bite varies from zero percent for the most tax-efficient
funds to 5.6 percent for the least efficient.
ratio is the best indicator of how much buying and selling goes on within a fund.
Harding, an analyst with Morningstar, says the average turnover ratio for managed
domestic stock funds is 130 percent.
"Many managers claim
to be long-term investors when, in reality, the average mutual fund manager is
turning the portfolio more than once a year.
always the case that lower turnover always means greater tax efficiency,"
says Harding. "But, generally, really low turnover leads to greater tax efficiency
because it means management isn't selling stock as often, so the portfolio isn't
realizing capital gains."
Turnover ratio is best when
comparing two funds in the same category -- growth, value, and the like; but turnover
by itself doesn't always tell the whole story.
growth fund probably has 25 percent more turnover than the average value fund,
yet value funds can be less tax-efficient. A growth manager buys and holds the
winners and sells the losers. A value manager buys something at a discount to
its intrinsic value and has a strict sell discipline," says analyst Fran
Kinniry at Vanguard.
At times, trading can be a means to greater
tax efficiency. A manager may be selling losers to offset gains in the portfolio.
telling turnover ratio
The National Association of Investors Corporation,
based in Madison Heights, Mich., considers turnover a key number when evaluating
mutual funds -- even if the fund will be held in a tax-deferred retirement portfolio.
look for a turnover ratio of 20 percent or less," says Dennis Genord, manager
of NAIC's mutual fund education program. "We're from a long-term perspective.
You need to get a grip on what's being invested in the fund. If that fund has
a 100 percent turnover ratio, you can't get a feeling for what the fund invests
Another consequence of heavy trading by a fund manager
is that every trade results in transaction costs that get passed on to shareholders,
Genord points out.
Sometimes the manager has little choice
but to sell. When the market tanks and investors sell their shares, managers may
have to sell stock if there's not enough cash on hand to meet shareholder redemptions.
flip side of trading too much is that trading too little may mean there are large
capital gains that will result in an extra big tax when the shares within the
fund are eventually sold.
Investors who buy into a fund shortly before a distribution
is made (called "buying a distribution") can get hit with a capital
gains tax when their shares haven't had time to appreciate. This is always a nasty
surprise, especially so if the gains have really built up.
Harding says that's why it's important to know the capital gains exposure of a
"Morningstar always publishes this. It's the total
unrealized gains of a fund and could be a clue to the potential capital gains
exposure. It's calculated as a percentage of net assets. If the management team
has a low turnover approach, it may not be a big concern. The other thing is the
shares they're selling are probably long-term gains that are taxed at a lower
A key to not "buying a distribution,"
is to check the fund's distribution schedule before purchasing shares. That information
is in the prospectus and may also be on the fund family's Web site.
SEC wants investors to see the impact taxes have on returns generated by the funds.
It now requires that mutual fund families be upfront about the effect taxes have
on each fund. After-tax returns must be presented in two ways in the prospectus
and in any advertising that makes claims about the tax efficiency of the fund.
first number is the "return after taxes on distributions." It's the
tax effect of the manager's trading of shares within the fund.
second number, "the return after taxes on distributions and the sale of fund
shares," is the effect of both the manager's trading within the fund and
the taxable gain or loss realized by shareholders for selling shares.
numbers are meant to show a worst-case scenario, so the taxes are computed at
the maximum federal income tax rate. The after-tax return for both cases must
be stated for one-, five-, and 10-year periods.
John Nestor says the tax information may help get investors to focus on what's
important when selecting a fund.
"There's no question
that too many investors place too much emphasis on past performance in choosing
funds when there are a number of factors that weigh heavily in the ultimate performance
of a fund."
are just a few of the Web sites where you can find the turnover rates and after-tax
returns for hundreds of mutual funds. Those numbers are just a part, but an important
part, of the total picture you need before deciding to invest in a mutual fund.