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Taxes Pose Biggest Threat to Stock Funds


"For every benefit you receive, a tax is levied" - Ralph Waldo Emerson

Equity mutual fund shareholders are losing 25% of their returns annually due to taxes paid on their investments, according to a recent study by fund tracking firm Lipper of New York.

Lipper estimated that between 49.2% and 54.3% of the $6.89 trillion dollars invested in open-end mutual funds are owned by taxable investors who, on average, relinquish between 1.98 percentage points and 2.5 percentage points in returns to the government. And while stock fund shareholders have given up 25% of their returns over the last 10 years, fixed-income fund investors are surrendering up to 45% of their returns to the government. In the taxable fixed-income macro-classifications, the tax burden was often two to three times larger than any other component of drag on performance, including loads and expenses.

These alarming statistics are the product of a comprehensive examination of the history, trends, current legislation and tools that fund shops and individual investors need to better manage their taxable mutual fund accounts. More specifically, Lipper reviewed the impact of basic tax principles on the fund industry over time and recent changes in performance presentation standards and tax laws regarding funds.

In 2003, registered investment companies distributed the second-lowest amount of capital gains and income dividends since 1995, according to Lipper. Additionally, last year marked the strongest year since 1967 for equity mutual funds, which posted a robust 33.03% gain.

Those significant feats notwithstanding, U.S. fund shareholders still forked over an estimated $6.5 billion to Uncle Sam last year.

Another key finding of the study was that from 1994 to 2000, dividend income ranged from 10% to 33% of total equity distributions. While the amount of cash doled out has remained somewhat stable, the proportion has grown tremendously during the last three years. What that means in plain English is that investors should brace for an uptick in capital gains over the next few years as tax-loss carryforwards -- tax benefits that allow business losses to be used to reduce tax liability -- are exhausted. Mutual fund dividends are paid out of income, typically on a quarterly basis from the fund's investments. Taxes paid on those dividends vary depending on whether the distribution resulted from capital gains, accrued interest or dividends received by the fund.

Clearly, there is plenty of room for improvement in managing taxes levied on mutual fund shareholders. With that in mind, Lipper Senior Analyst Tom Roseen, author of the report, offered some key recommendations to help guide investors on the use of after-tax performance measures and the creation of tax-efficient and tax-managed funds. First, he suggests that legislators remove the "sunset" provision of the $350 billion Jobs and Growth Tax Relief Reconciliation Act of 2003.

The act, passed by President Bush last May, implemented sweeping reforms that helped mutual fund investors by lowering individual tax rates, reduced taxes on long-term gains and reduced the applicable rate on some dividend distributions. However, the provisions of that piece of legislation are only temporary due to a 2010 expiration date under the sunset provision.

Second, Roseen urges fund complexes and their respective boards to place greater emphasis on serving the taxable investor by not only advocating after-tax performance, but also providing better compensation packages that reward tax-efficient behavior at the fund level. "Boards should make after-tax performance a part of their annual renewal process and regular periodic performance review," Roseen wrote in a 107-page report. In terms of portfolio management, he believes fund managers need to focus more on the implications taxes have on portfolios.

But the onus does not fall entirely on fund management. In fact, taxable investors should take it upon themselves to be more vigilant in evaluating all the components of drag on performance, Roseen said. That includes looking at gross return, total return, load-adjusted return, pre-liquidation after-tax return, and post-liquidation after-tax return. In order to ensure an apples-to-apples comparison, Lipper encourages investors to conduct analysis within load structure.

"While total returns are convenient for reporting purposes and press-related needs, we recommend that investors and their advocates become more familiar with the use and interpretation of load-adjusted and SEC standardization returns and the recently created pre- and post- liquidation after-tax returns in their analysis of fund performance," Roseen said. "With broader industry focus on after-tax returns, taxable mutual fund shareholders will begin to be better represented in an arena that has historically focused on the overstated results of total return."

For stock funds, pre-liquidation tax burden is the largest drag on performance for the 10-year period ended Dec. 31, 2003.

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