Taxes may be a bigger deal than alpha
Joe Huber is a big investor in mutual funds.
The founder and chief executive officer of El Segundo, California-based Huber Capital Management runs four funds he invests in, so it’s a safe bet he’s a fan of those. But there’s one thing he’s never liked about the investment format in general. U.S. mutual funds get kind of a raw deal from the government: “You have to pay taxes on capital gains every year — short-term, long-term capital gains,” Huber says, even if you don’t sell your fund shares.
Why is that? As regulated investment companies, mutual funds aren’t subject to tax, provided they distribute at least 90% of their income each year. So when a fund manager sells securities at a profit, those gains get passed through to shareholders.
“Even if the fund goes down, you still have to pay taxes,” says Huber, who earned his MBA at the University of Chicago, studying behavioral economics with Nobel laureate Richard Thaler. “I’ve never really felt that was fair to the investors.”
By contrast, that doesn’t happen for other investments. If you own a stock, you’re not on the hook for taxes on capital gains until you actually sell.
Huber, 51, who previously managed $40 billion in value portfolios at Hotchkis & Wiley Capital Management, started his firm in 2007. Huber Capital now manages about $800 million. Because he’s a big investor in the funds, he made a conscious decision when opening the shop to minimize or eliminate the capital gains they distribute. To be clear, that doesn’t mean giving up gains. It involves using a handful of strategies to increase tax efficiency.
One, for example, is tax-loss harvesting: selling a loser in a fund’s portfolio before the end of the fiscal year to offset realized gains, and perhaps buying the stock back after 31 days to avoid the Internal Revenue Service’s wash-sale rule. (This rule prevents taxpayers from deducting a capital loss when an almost identical stock or security is sold and bought within 30 days.)
“Over time, we’ve kind of perfected it — with some well-known techniques and some less well-known techniques — to a point where I think that we can really perpetually not ever show any taxes to the underlying fund holders,” Huber says.
How much of a difference can tax management make? A lot, according to Huber.
“The single biggest controllable cost to an investor is the avoidance of excessive government donations,” he says. The tax drag from fund distributions can be bigger than the alpha of a top-performing manager and considerably larger than the difference in fees between funds. “I think that the tax piece is actually bigger than the two combined,” Huber says. And it’s something that can be controlled by an active manager, he says.
Consider a hypothetical fund with a net asset value of $20 a share. In a particular year, the fund distributes a $1 short-term capital gain. If you’re in the highest tax bracket and live in California, you could end up paying the 37% federal tax rate, plus the 3.8% Net Investment Income Tax, plus 13.3% in state taxes — a total of 54.1%. You’d thus pay 54¢ in taxes on that $1 per share distribution. Given the $20 NAV of the fund, that’s a 2.7 percentage-point drag on your return.
That’s a made-up example. Yet if you screen for mutual funds with a high turnover, it’s not hard to find funds that have distributed short-term capital gains of more than 10% of NAV in a given year — implying a potential tax drag of more than 5 percentage points.
Huber extends the argument for tax efficiency by considering how it would affect an investor’s return over time. If you have a tax drag of 5 percentage points, your returns are compounding on only 95¢ of principal, instead of on a full dollar. Over time, that adds up. According to Huber, if you do the math on two funds with identical pretax returns, one of which is tax-efficient and the other not, an investor’s stake in the tax-efficient one could end up being more than twice as large after 20 years.
So why don’t investors and wealth advisors focus more on after-tax returns? The reason, in part, is that about half of the total $17.7 trillion in U.S. mutual funds is in tax-sheltered retirement accounts such as 401(k)s, according to the Investment Company Institute. Tax drag doesn’t matter to such investors. The lack of attention on taxes can also be pinned on complexity. Investors have different tax situations. In the U.S., there are seven federal tax brackets and 50 state tax regimes, some of which also have different brackets.
Michael Cuggino, president and portfolio manager at the $2 billion Permanent Portfolio Family of Funds in San Francisco, also focuses on after-tax returns.
“People don’t realize that taxes are sometimes the biggest expense item for an investor,” he says. “If you’re a heavy-trading, high-turnover type of product — which a lot of managers are, based on trying to maximize gross performance — they’re likely going to incur a lot of shorter-term gains that are going to be taxed at higher rates.”
The tax treatment of mutual fund capital gains derives from some “archaic” lawmaking, according to Russel Kinnel, director of manager research at Morningstar Research Services in Chicago.
“The idea was, we don’t want these mutual funds to let people hide from the tax man by not paying on their dividends—and rising capital gains were sort of an afterthought,” he says. “I think a far more sensible approach would be, maybe you pay on the income along the way just as you would from a stock, but you shouldn’t pay your capital gains until you’ve sold the investment.” Kinnel doesn’t expect lawmakers to change that anytime soon, however. “Mutual funds are kind of a middle-class thing, and therefore Congress never really has the motivation to do anything for mutual fund investors,” he says.
For its part, Morningstar calculates a tax-cost ratio, essentially an estimate of how much a fund investor would pay out in federal taxes (not taking into account state levies). According to Kinnel, taxes reduce the return of the average equity fund by 1.73 percentage points a year over three years and 1.58 percentage points over five years.
U.S. regulators have taken steps aimed at helping people evaluate the effect of taxes on their investments. In 2001, the SEC adopted a rule requiring mutual funds to disclose after-tax returns in their prospectuses. These numbers are based on a standardized formula that assumes the highest federal tax rate but no state taxes. You can usually find these disclosures in a fund document by searching for the phrase “after taxes on distributions.” The returns are reported in two ways: as if the investor held on to the mutual fund shares, and as if she sold them.
If you look at the prospectus for a tax-efficient vehicle such as the Vanguard Total Stock Market Index Fund, its one-year return after taxes on distributions was only 0.35 percentage point less than its gross return before taxes for 2018. In part, that’s because, as Morningstar’s Kinnel points out, index funds tend to be more tax-efficient than actively managed funds. But in addition, as Bloomberg News reported last year, Vanguard patented a method for essentially washing capital gains out of mutual funds via so-called heartbeat trades in the exchange-traded fund share class of a particular strategy. Vanguard’s Total Stock Market strategy was the first to use the approach; as a result, the mutual fund has distributed no capital gains to investors since 2001.
To see the income and capital gains that a fund has distributed, you can use the Dividend/Split Summary function on the Bloomberg terminal. For the distributions by the $49 million Huber Capital Equity Income Fund, run (HULEX US Equity DVD GO) on the Bloomberg terminal.
If you’re wondering why this is the first time you ever thought about taxes on mutual funds, you’re not alone. Even Huber, who started his career in asset management nearly three decades ago at Goldman Sachs, didn’t quantify the effects of taxes on fund performance until last year.
For that matter, in more than 20 years of talking with wealth advisors and family offices, not one person had ever asked him about the taxability of a fund, he says. “And when you think about it, that’s by far the biggest amount that you can add to the value of your portfolio — much more than the alpha that a manager will generate over time.”
Asmundsson is G0 editor of Bloomberg Markets.