One of my favorite features in Morningstar is the “Tax” tab which allows you to compare the pre-tax return and tax-adjusted returns of mutual funds and ETFs. Many investors never bother to consider the tax-efficiency of their investments, but if you are investing in a taxable account, this is a key consideration.
I recently looked up the five largest actively managed equity mutual funds and compared their performance to a passive, Large Cap index fund we use in our portfolio models, the iShares Russell 1000 ETF (ticker IWB).
Here are the gross annualized returns (pre-tax), over the past five years through 2/29/2016:
| Fidelity Contrafund (FCNTX) | 10.08% |
| American Income Fund (AMECX) | 6.95% |
| Growth Fund of America (AGTHX) | 8.99% |
| Capital Income Builder (CAIBX) | 5.66% |
| Vanguard Wellington (VWENX) | 7.48% |
| iShares Russell 1000 (IWB) | 9.78% |
Already, you can see that four of the five most popular actively managed equity funds lagged the Russell 1000 index fund. And several were not even close. Only the Fidelity Contrafund was ahead of the index over the past five years.
Next, here are the same funds, showing their tax-adjusted returns, which also includes the upfront sales loads charged on the three American Funds.
| Fidelity Contrafund (FCNTX) | 8.92% |
| American Income Fund (AMECX) | 4.21% |
| Growth Fund of America (AGTHX) | 6.34% |
| Capital Income Builder (CAIBX) | 2.90% |
| Vanguard Wellington (VWENX) | 5.83% |
| iShares Russell 1000 (IWB) | 9.28% |
After tax, the return of the Contrafund drops from 10.08% to 8.92%. Compare this to the iShares Russell 1000, which had a pre-tax return of 9.78% and an after-tax return of 9.28%. The tax-efficiency of ETFs makes a noticeable difference.
Morningstar assumes the highest Federal tax bracket and a long-term capital gains rate of 15%. And while not everyone is in the highest tax bracket, I would point out that their analysis does not include the 3.8% Medicare tax or any state income taxes, which can be substantial in places like New York or California.
What can you do to reduce the impact of taxes on your portfolio? Here are three take-aways:
1) Consider the after-tax returns and not just gross returns when selecting funds for a taxable account.
2) Don’t discount the tax advantages of ETFs. Often, their returns are even more compelling when taxes are considered.
3) Place your most tax efficient vehicles in taxable accounts, and save positions which are more likely to generate taxes for your IRA or other qualified account.
