Lipper Senior Research Analyst Tom Roseen on "Business for Breakfast" 1060 KRCN

Tuesday, April 26, 2005

A. That's right. In our soon-to-released research report, which wassponsored this year by Eaton Vance, we found that taxable shareholders paidan estimated $9.6 billion to Uncle Sam in 2004! That was a 48% increasefrom last year. And even though the mutual fund related tax bill has beencomparatively low over the last four years, taxes have remained, onaverage, the largest drag on performance over the last ten years.

Q. Can you break that down a bit for us?

A. Absolutely, the average taxable equity mutual fund investor lostapproximately 20% of his or her pre-tax returns or about 1.8 percentagepoints per year over the past ten years because of taxes! Now that may notsound like a lot, but consider that the average drag on performance due toexpenses was 1.5% per year over the last ten years, we can see that taxeshave eaten up more than expenses have.

Q. Can you give us an example of how much this might impact an investorover the long run?

A. Tax burden really does matter. Let's use a hypothetical compoundingexample. Suppose we invest $10,000 and assume an average 10% return overthe 30-year period. Our future value, excluding any tax implications,would grow to $174,494. However, if we factor in the average tax loss fromthe study and assume an 8.2% return, the future value would be a meager$106,370, after a loss of $68,124 because of taxes.

Q. That loss is almost 7 times the amount you originally started with!So, what about taxable fixed income funds?

A. Unfortunately, for fixed income funds the tax drag on performance iseven worse. We estimate that the average taxable fixed income investorsurrendered about 38% of their pre-tax returns or on average 2.5 percentagepoints per year over the last ten years to the taxman. In many cases thatis two to three times greater than the average fixed income expense ratio.

Q. Investors must have been doing a lot of buying and selling.

A. Well that is where the rub is. All of these estimates assume thatthe investor had a buy-and-hold strategy, and the tax estimates are onlyfrom dividend income and capital gains passed through by mutual funds.

Q. Didn't the 2003 tax bill lower tax rates on distributions?

A. It sure did, and equity investors, in most cases, now pay only 15% onqualified dividend income (it used to be the highest marginal tax rate) andthe long-term capital gains tax rate dropped from 20% to 15%. However, forequity funds, short- and long-term capital gains jumped 340% and 539%,respectively, from their relatively low 2003 levels. We estimate thattaxable equity mutual fund investors relinquished about $5.7 billion toUncle Sam?s coffers in 2004.

Q. So what can investors do?

A. Take a greater interest in after-tax performance. Almost all mutualfunds are required to provide after-tax returns in their literature, andthere are many other information sources on tax efficiency as well. Forexample, Lipper provides a tax efficiency measure at www.lipperleaders.com.However, investors need to be aware that they should never screen on taxefficiency alone.

Q. Why is that?

A. If a fund is poor performer and never passes though any capital gainsor income distributions, it will appear to be very tax efficient, when infact it has been just a losing fund. I suggest that the first screen be onsome measure of risk and return, such as, Lipper Leaders for ConsistentReturn, Preservation or Total Return. Once the top performers in thesecategories have been identified, the taxable investor can apply a secondscreen on the remaining funds for their tax efficiency. This will helpinvestors identify funds that best meet their needs.Q. Are there tax efficient mutual funds?

A. Most definitely. Investors worried about the impact taxes have ontheir returns can turn to tax-managed funds. The primary goal of thesefunds is to maximize after-tax returns through various practices. Otherconsiderations are index funds, exchange-traded funds, and variable annuityaccounts. Each of these products has it?s own unique tax advantage. Oh, anddon?t forget to fund your IRAs, 401(k)s, and other qualified plans. Thebenefits of tax deferral or tax exemption are obvious.

Q. How about for fixed income investors?

A. For current income, investors can compare and contrast the taxefficiency and after-tax returns for municipal bond fund versus taxablefixed income funds. Our recent study shows that in many cases thebefore-tax return was higher for taxable funds with similar maturities andrisk, but after-tax, munis often provided better returns. Investors alsocan evaluate the benefits of seeking current income from equity incomefunds that benefit from the new low tax rate for qualified dividend income.Income generated from traditional bond funds is taxed at the investor?shighest marginal tax rate (up to 35%), whereas equity distributions fromqualified dividend income are now taxed at the new low 15% rate. Fundfamilies offer many alternatives, but the investor must know what questionsto ask.

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Don Cassidy is a Senior Research Analyst at Lipper specializing in fund flows, exchange-traded funds, (ETFs), closed-end funds, equity fund performance, and author of Trading on Volume (McGraw-HIll).