Mutual fund investors are typically allergic to fees, shopping for funds with low expense ratios that won’t chip away at returns. But there’s a less visible kind of charge they might be missing, according to new research from Texas McCombs, that can cost as much as fees: income taxes.

When mutual funds sell stocks and realize capital gains, they’re required to distribute that income to shareholders. Those shareholders, in turn, owe Uncle Sam. Over 26 years, the study discovered, the average tax burden on equity mutual funds was 1.08% of their assets — nearly as high as the average expense ratio of 1.14%.

“The average equity mutual fund generates quite a bit of tax burden,” says Clemens Sialm, finance professor at Texas McCombs. “Most investors don’t consider taxes as much as they should.”

But he found an even better reason to pay attention to taxes. Funds with lower tax burdens had higher-than-average returns. If investors seek out those funds, says Sialm, “They can have their cake and eat it, too.”

Trading and Taxes

Tax burdens differ from fund to fund, because trading styles do. Short-term capital gains — stocks held less than a year — get taxed at higher rates, up to 37%. Holding stocks more than a year brings the top rate down to 20%.

If fund managers act on those distinctions, they can save money for their investors. “Often, it’s fairly easy to avoid a higher tax rate on a capital gain,” says Sialm.

“If I’ve held a stock for 11 months, it’s better to wait one more month to sell it.” — Clemens Sialm

The opposite goes for capital losses. If a fund sells a losing stock before a year is up, a shareholder can write off the loss at the higher rate, against short-term income.

Sialm feared, however, that trying to minimize taxes might have a negative side-effect. It might lead to lower returns, because managers would be less flexible on when to sell.

To find out, he and Hanjiang Zhang of Washington State University looked at U.S. equity mutual funds with more than $10 million in assets, from 1990 to 2016. Over that period, tax rates rose and fell, between a high of 43% and a low of 15%. To calculate the bite on capital gains, the researchers used the rates in effect when a fund sold a stock.

What they found was the opposite of what they expected. Low-tax funds actually outperformed the average fund, both before and after taxes. A 1.18% drop in a fund’s tax burden boosted its return 0.55% before taxes and 0.99% after taxes. “Tax-managed funds aren’t sacrificing performance,” Sialm says.

What made the tax-efficient funds do so well? The answer, Sialm found, was better all-around management. Funds that had lower tax burdens also displayed better stock picking abilities. They showed lower trading costs, as well — presumably, because they traded less often.

“They have a more sophisticated and more holistic approach,” Sialm says. “They take taxes and trading costs into account, and they have better stock-selection abilities.”

Finding Low-Tax Funds

The lesson, Sialm says, is that fund shoppers should look beyond fees and check out taxes as well. “You have to dig deeper in the prospectus, but the information is there,” he says.

Research websites like Morningstar can help. They list the taxable distributions as well as the performance of a fund.

Another way to tamp down taxes, he says, is to shop for certain kinds of funds — ones that tend to hold stocks longer than a year:

· Tax-managed funds, which reduce capital gains by balancing them against losses. Their after-tax returns were 0.81% better than similar funds that weren’t tax managed.

· Momentum funds, which buy stocks while they’re rising and sell when they start to fall. “If you have a winning stock, you hold on to it longer,” Sialm says. “If it’s a losing stock, you sell it and take the capital loss.”

· Index funds, which try to match indexes like the Standard & Poor’s 500. They hang onto a stock for as long as it’s part of the index.

It’s a strategy that Sialm practices himself, as an advisor to McCombs’ MBA Investment Fund, where select students make investments with real money. “If all else is equal, we try to avoid short-term capital gains and harvest capital losses,” he says. “We teach students to take taxes into account.”

“Tax-Efficient Asset Management: Evidence from Equity Mutual Funds” appears in the April 2020 Journal of Finance.

Story by Steve Brooks