The views expressed are those of the author at the time of writing. Individual teams may hold different views. The value of your investment may become worth more or less than at the time of original investment.
Reviewing investment performance can be challenging for taxable investors. A typical mutual fund prospectus presents taxable clients with three different sets of returns. Despite this common framework, these numbers are often misunderstood, potentially leading to suboptimal investment decisions.
Clearing the confusion
An overview of the data presented in a typical prospectus could help taxable investors more effectively use this framework to understand their investments.
RETURN BEFORE TAXES
These figures are typically the focus of investors but do not reflect fees or taxes.
RETURN AFTER TAXES ON DISTRIBUTIONS
This second set of returns includes taxes on income realized (and, in the case of a mutual fund, distributed) by the fund during the current year. These are pre-liquidation returns.
RETURN AFTER TAXES ON DISTRIBUTIONS AND SALE OF SHARES
Finally, this set reflects taxes on both realized taxable income and on a gain or loss realized on a hypothetical liquidation of an investment in the fund. These are post-liquidation returns.
Considering both pre- and post-liquidation returns is a vital part of analyzing an investment. The return differential can be quite significant. The current 23.8% federal income tax rate on long-term capital gains sets a theoretical minimum on post-liquidation “tax drag.”
Understanding the historical after-tax return can help taxable clients better evaluate prospective investments, in the context of a desired holding period. To learn more, see the practical example and three key principles we live by outlined below.
The cost difference between pre- and post-liquidation returns can be substantial. An investor would have kept 81% of pre-tax income over a 10-year period pre-liquidation. But including liquidation costs, the investor would have kept only 75% of pre-tax returns.
Leveraging this tax framework
Three principles we live by:
We focus on after-tax returns.
After-tax returns net of fees allow us to see both pre-tax investment skill and the degree to which an investment team is able to minimize taxes.
For long-term investments, we focus on pre-liquidation returns.
For core equity holdings, we believe tax-efficient compounding is often more important than taxes to be paid in the distant future.
For shorter horizons, we focus on post-liquidation returns.
While compounding is still meaningful for tactical allocations, taxes on liquidation have a bigger present-value impact on their shorter holding periods.