Excerpted from Common Sense on Mutual Funds by John C. Bogle, pages 283-284
It's important to recognize that what's happening here is largely the product of the inordinately high portfolio turnover rates of mutual funds. Twenty-five years ago, fund portfolio turnover averaged 30 percent; today, it averages nearly 90 percent. Individual investors may hold stocks for decades, and families may hold them for generations, but mutual funds are rushing to buy and sell their stocks with seemingly carefree abandon based on transitory changes in prices and without concern for tax consequences. This behavior sharply reduces the returns generated for their taxable owners.
Further, some fund managers are so trigger-happy that many of the gains are short-term in nature (less than one year) and are taxed at ordinary income rates. In recent years, some 30 percent of fund gains fell into this category, but with the end of the long-standing limitations on short-short gains under the so-called Taxpayer Relief Act of 1997, this figure could well increase. Now, portfolio managers can feel free to realize an unlimited percentage of the fund's income in the form of gains realized in less than 30 days. For mutual fund shareholders, the economic value created by this change in the law is dubious in the extreme.
YAHOO! FINANCE TIP
Yahoo! Finance reports a mutual fund's annual turnover percentage on its profile page. For an example, see VFINX's profile page.
|
It is highly unlikely that fund turnover will slow so greatly that it will mitigate the gain realization issue. Reducing a fund's turnover from 150 percent to 100 percent simply doesn't matter. Substantially all gains are realized fairly quickly. Authoritative studies suggest that turnover rates would have to be reduced to 20 percent or less to engender a material lessening of the tax burden. But any turnover, by forcing shareholders to give up the value of that implied interest-free loan, has a negative impact on the net returns enjoyed by investors.What happens when the basic strategy of a fund calls for limited turnover? Something very good for fund investors. The amount of tax due falls, and the after-tax return rises accordingly. It is that simple. As taxes are deferred, returns rise significantly with each additional year that an investor elects to hold fund shares. And through tax elimination - for example, if an investor's heirs receive the shares with a stepped-up cost basis at the time of the investor's death - after-tax returns leap ever higher.
