Mutual funds with lower tax burdens have higher returns

After a wild couple of months of equity market volatility, many mutual fund investors are now cautiously exploring how best to rebalance their portfolios. As they do so, new research from the McCombs School of Business at The University of Texas at Austin says they should keep an important factor in mind: taxable capital gains.

McCombs finance professor Clemens Sialm compared tax burdens and mutual fund performance in a new study published in the April 2020 issue of The Journal of Finance. The results showed a direct correlation in tax rates and performance, indicating that tax-efficient funds provide higher gains for investors and, therefore, more income for shareholders.

"The average equity mutual fund generates quite a bit of tax burden," Sialm said. "Most investors don't consider taxes as much as they should. So, in the coming months, as many investors make many portfolio adjustments meant to maximize their long-term objectives, they would be wise to rethink this issue," he said. "Harvesting losses can help offset future capital gain realizations, for example."

Short-term capital gains on stocks held for less than a year get taxed at rates as high as 37%. Holding stocks more than a year brings the top rate down to 20%.

"Often, it's fairly easy to avoid a higher tax rate on a capital gain," Sialm said. "If I've held a stock for 11 months, it's better to wait one more month to sell it."

In order to see whether minimizing taxes had negative effects on fund performance, Sialm and Hanjiang Zhang of Washington State University looked at U.S. equity mutual funds with more than $10 million in assets from 1990 to 2016. During that period, tax rates rose and fell between a high of 43% and a low of 15%. To calculate the bite taken by capital gains, the researchers used the rates in effect when a fund sold a stock.

What they found proved their theory. Low-tax funds actually outperformed the average fund, both before and after taxes. A 1.18% drop in a fund's tax burden boosted its return 0.55% before taxes and 0.99% after taxes.

"Tax-managed funds aren't sacrificing performance," Sialm said.

What made the tax-efficient funds do so well, Sialm found, is better all-around management. Funds that had lower tax burdens also displayed better stock-picking abilities. They also showed lower trading costs—presumably because they traded less often.

"They have a more sophisticated and more holistic approach," he said. "They take taxes and trading costs into account, and they have better stock-selection abilities."

Based on this research, fund shoppers should look at both fees and taxes when making decisions. The researchers said one way to tamp down taxes is to shop for certain kinds of funds—ones that tend to hold stocks for longer than a year:

• Tax-managed funds, which reduce capital gains by balancing them against losses. Their after-tax returns were 0.81% better than similar funds that weren't tax managed.
• Momentum funds, which buy stocks while they're rising and sell when they start to fall. "If you have a winning stock, you hold on to it longer," Sialm said. "If it's a losing stock, you sell it and take the capital loss."
• Index funds, which try to match indexes like the Standard & Poor's 500. They hang onto a stock for as long as it's part of the index.