The financial markets inundate us with performance numbers. This stock was up 12.32 percent this year. That currency dropped 5.68 percent. This is for good reason. After all, measuring our increase or decrease in wealth is a big part of figuring out how well or poorly we did. But often performance figures don’t tell the whole story. The big question is not so much how much we made today or this week or this year, but really how much are we going to take home?
A failing in many performance measures is that they do not take into account the specific tax circumstances of each investor. Of course, it is a bit much to ask that any statement of an investment’s track record breaks down the individual consequences for every investor, but that just makes it all the more important to not take performance at face value.
Take Time to Understand the Complexity of Taxes on Investment Income
One key attribute to investments, and specifically mutual funds, which is getting more and more attention from advisors is income. That same attribute has also been a significant focus of the IRS and other global tax authorities for some time as well. So it is no surprise that the after tax return on a specific income producing investment is somewhat complex. But, since maximizing take home returns is partly a function of the tax level for an investment, looking at what share the government is taking is worth any financial advisor’s time.
As you know, the U.S. government recently decided to raise income taxes on both ordinary and investment income. While the rules pertaining to ordinary income are largely based on one’s tax bracket and therefore fairly straightforward, those related to investment income are far more complex since the character or type of income dictates how it’s taxed. On one hand, some income, like that from taxable bonds, is treated in much the same way as W-2 earnings (absent a few other taxes) with the tax rate now as high as 39.6 percent. On the other hand, capital gains and dividends from equities are given more preferential treatment, with the highest rate being 20 percent. In all cases other than an investor who pays zero tax (including non-profits, as an example), dividends are taxed at a lower rate than the corresponding ordinary rate.
Equal Can Be Different
How is this captured in performance numbers from mutual funds, which are designed to pass through taxation on investments to individual investors? In general, it is not captured. If a bond fund, taxed at an ordinary rate, has a five percent income return, it is reported as equal to an equity dividend portfolio that has an equivalent five percent income return. In both cases, the price return of the investment is likely to muddy the waters (an unchanged price is pretty unusual), but the key point remains -- the take home value of dividends is higher than that of ordinary income in the form of bond yield.
Similarly, holding period can have a tremendous effect on take home returns. First, in order to claim the preferential dividend rate, investors must hold the dividend paying investment for at least 61 days during the 121 day period centered around the dividend payment date. And, of course, whether capital gains are short- or long-term is also a key part of the tax picture.
Dividends, Short vs. Long Term, and Other Key Tax Efficiency Metrics
The key takeaway from any analysis of performance figures is that maximizing the take home return from an investment requires any investor to examine both the type of asset and the length of the investor holding period. When looking at funds that pay dividends, a critical part of such analysis should be the degree to which the dividends are taxed at a short- or long-term capital gains rate. Once again, mutual funds are pass-through vehicles, so a shareholder in any fund is subject to the consequences of the manager’s decisions. Given that many investors ignore take home investment return, it is also true that many funds are not very efficiently managed since they can aim for what appears to be higher returns but what in fact, once taxation is taken into account, aren’t.
Some other key metrics that advisors should look out for when judging the tax efficiency of a particular portfolio are turnover, volatility, and embedded capital gains or losses. High turnover combined with high volatility will generally mean that a fund is generating a significant amount of capital gains and losses. These can offset one another to a great degree if the manager is paying attention to the shareholder tax bill, but a highly volatile fund with a short holding period raises the stakes. Embedded capital gains and losses occur when a fund has been subject to high volatility (as happens to all managers when the market has moved significantly). The manager can either hold positions that have increased in value where the gains have not been realized (which will lead to a future tax bill), or can hold positions that are at a loss or can have already sold positions at a loss. Losses (realized or unrealized) can be used in many cases to offset future gains.
Advisors should be sure to check these metrics to determine if a fund’s reported returns are as attractive (or unattractive) as they may seem.
Jason Brady, CFA, is a portfolio manager and managing director for Thornburg Investment Management. He is the head of Thornburg’s Taxable Fixed Income team.