Taxes take toll on total fund returns, Canadian research study finds

(April 8, 2003) Advisors have long recognized the danger of chasing performance: investors may be buying a fund just as it is peaking. But there’s another hazard to performance: data may disguise substantial tax liabilities.

A study by Canadian researchers suggests that taxes eat up as much as 15% of the average fund return, which is only 9%. And those taxes may fall on a substantial number of Canadians, since 54% of mutual fund assets are held in taxable accounts.

"Taxes exceed management fees and brokerage commissions in their ability to erode long-term investment returns," write Amin Mawani and Moshe Milevsky, both professors at the Schulich School of Business at York University in Toronto, and Kamphol Panyagometh, a post-doctoral researcher working with Mawani and Milevsky. Their work, "The Impact of Personal Income Taxes on Returns and Rankings of Canadian Equity Mutual Funds," to appear in the Canadian Tax Journal, analyzes the returns of 343 equity and balanced mutual funds over 10 years, from 1992 to 2001.

The impetus for the study was legislation in the United States that now compels mutual funds to disclose after-tax returns. To find Canadian after-tax returns, Mawani, Milevsky and Panyagometh applied the highest British Columbia income tax rate to fund distributions. They justify using the highest marginal rate by noting that Canadians making over $100,000 pay 78% of all capital gains taxes.

Their research turned up two major results. The first is that when funds are ranked for after-tax returns, the order generally differs from the pure performance rankings. On average, a fund can move 28 places up or down the rankings, the researchers found.

"It was really quite interesting," said Moshe Milevsky in an interview with Advisor.ca "We call it the scrambling effect. Nobody’s ever really said this fund is a top-performing fund if it’s inside an RRSP, but if it’s outside an RRSP it isn’t a top-performing fund. Nobody ever thought about it this way. That’s what we’re trying to introduce into the dialogue."

The second finding is size of the tax bite. On average, taxes on distributions amounted to 1.35%, reducing after-tax performance from 9.01% to 7.66%. The authors also found that, on average, investors lost 1% when liquidating their funds, thanks to capital gains taxes, making for an average 6.66% return over 10 years.

Milevsky concedes that that might not matter much to someone who is scraping together $500 a month for an RRSP contribution. But for a higher net worth investor, taxes can be hefty, and that’s something advisors should consider.

"When you’re sitting down with the client and the client clearly has the capability to go elsewhere, what can you as an advisor tell the client that’s cutting or new," says Milevsky. "You can start talking about the tax-efficiency of their portfolio and what funds they are holding, whether they should be swapping them, or holding them inside or outside the RRSP."

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To see the top 50 tax-efficient funds according to this research study, click here.

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For an executive summary of the report, click here.

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To read the whole study, please click here.

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Do you have any comments or questions about the results of this study? Special guest moderator Moshe Milevsky will be in the "Tax Time Tactics" forum of the Talvest Town Hall to answer your questions later this week. Post your message to your peers or to Milevsky himself in the “Tax Time Tactics” forum of the Talvest Town Hall on Advisor.ca.

Filed by Scot Blythe, Advisor.ca, sblythe@advisor.ca.

(04/08/03)