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Returns Look Better Through After-Tax Glasses


Before firms complain about having to show after-tax returns in prospectuses and sales literature, they should take a look at this year's numbers. The post liquidation after-tax returns for funds with negative returns in 2001 will actually be above the pre-tax returns.

As a result, some fund firms are considering taking advantage of that by using those returns in sales materials.

This month, the after-tax rule for advertisements and sales material went into effect, and it goes into effect for prospectuses on Feb. 15. Only funds that voluntarily include after-tax returns or funds that claim to manage or limit the effect of taxes on performance are required to comply with the new rule for advertisements.

The rules were adopted by the Securities and Exchange Commission last January. When the rule was proposed, the fund industry groaned. Not only would it be an added expense to calculate the after-tax returns, but it would lower their yields and confuse investors, fund executives said at the time. (See MFMN, 4/3/00). The idea that yields might actually go up because of after-tax reporting was never addressed.

"It's pretty ironic that the first year this rule is implemented, most funds are going to have higher after-tax returns," said Lawrence Vogel, treasurer at J. & W. Seligman & Co.

The question is whether this is really an advantage for fund companies, and whether firms will decide to incorporate after-tax returns in sales material where including performance is voluntary. After all, while the after-tax returns may be higher, they're still generally negative. Also, under the new rules, firms can't advertise after-tax returns by themselves, and so the pre-tax figures will still be right there for investors to see.

Weighing the Advantages

But, just as annoyed firms felt investors would pay too much attention to after-tax returns when they were lower, some are thinking they'll do the same to higher returns, and are considering using that in their advertisements, said John Picard, a principal at Picard & Co., a financial services marketing firm. There is some reluctance, however as firms are worried that this is a short-lived opportunity since the returns will likely revert to what they were, he said.

"I've had some discussion about this issue with my clients, and I know that some companies are definitely exploring the after-tax opportunity," Picard said . "There is some concern, however, that if they establish a platform like that and train and educate the marketplace to expect to see after-tax returns, they'll be walking into a trap."

Picard declined to name the funds he's talked to. J.P. Morgan Fleming Asset Management and Strong Investments, contacted separately, said they had no plans to add after-tax returns to their advertisements.

The problem with taking advantage of the after-tax number is that it hurts your long-term performance numbers, which firms are protective of, said Vogel. Still, investors often are attracted to recent performance and so that might be the marketing priority, he said. Also, the idea might influence fund marketers who want to advertise their long-term returns, but were reluctant to do so because of having to include horrible one-year numbers, Picard said.

Use of after-tax results is still voluntary in marketing materials. Because of that, some firms worried about the lingering effect of marketing after-tax numbers may just shift back to their normal advertising, said Picard. Firms in the past have engaged in seasonal advertising, for example, promoting after-tax numbers during tax season and then gone back to before-tax data, he said.

"The question is how much you're willing to play with it," he said "Right now, no one is being very aggressive about it, but I really expect that to change. I know certain advertisers that want to be aggressive with this, and so I expect that there will be an opportunistic approach and firms will try to exploit the better after-tax numbers in the short term."

How It Works

The after-tax reporting rule requires that funds show, in standardized tabular format, before-tax returns, and returns after taxes on distributions before and after liquidation for one-, five-, and 10-year periods.

The returns must assume a hypothetical $1,000 one-time initial investment and any sales load or other reduction. Also, the after-tax returns must be calculated using the highest applicable individual federal income tax rate.

Surprisingly, under the new rules, firms are allowed to assume that, when capital losses occur, investors can use them to absorb capital gains realized outside that fund, said Vogel. Not all investors will have capital gains to offset, he explained. And even though an investor is allowed to deduct losses, that amount is limited to $3000.

While pre-liquidation after-tax returns will always be lower than pre-tax returns, because of that assumption post-liquidation returns will be higher for funds with negative yields. Ignoring load and distribution costs, if a fund moves from $1,000 to $800, it has a 20% loss. The tax credit on that $200 loss using the highest tax rate of 39.1% is $78.20. Incorporating that credit into the yield changes it from -20% to -12.8%.

For actual funds, that distinction can make a miserable fund look a little less miserable or even convert the yield from one that's slightly negative to one that's slightly positive. For example, the average return this year for large-cap value funds is -12.04%, but their average post-liquidation after-tax return is -6.63%, according to Morningstar. Mid-cap value funds move from -.63% to .26%, while large-cap growth go from -38.92% to -25.94%.