Beware the Tax Drag on Non-U.S. Equity Funds
Increased capital gains tax bills may decrease after-tax returns for non-U.S. equity mutual funds in the coming years. Make sure to prepare your clients’ portfolios before it’s too late.
Taxes are the hidden expense ratio. The Global Financial Crisis, when global stocks dropped -42% in the calendar year 2008, wasn’t all bad for mutual fund investors. Many funds had realized losses which they were able to carry forward into future years to be used to offset future gains. The tax offset is called Capital Loss Carry Forward.
Since 2008, many mutual funds have depleted their CLCFs in order to offset gains on strong U.S. equity returns. As a result, taxable distributions have generally increased while after-tax returns have decreased. According to data from Morningstar and calculated by Russell Investments, U.S. equity funds (active, passive, ETFs) as a whole gave up 2% of returns to taxes for the three-year period ending June 2016. That is almost twice the ten-year average. For example, a mutual fund with a 10% pre-tax annualized return over the last three years would actually have had a return of only 8% on an after-tax basis.
The 2% loss of return (“tax drag”) is a hidden expense ratio that can have a material impact on an investor’s ability to reach their desired outcomes. Too many investors fail to consider the tax drag as a factor when evaluating taxable investment options. While each investors’ situation is different and the following should not be considered tax advice, there are some key points advisors and their clients should consider.
There’s a looming tax hit for non-U.S. equities. Non-U.S. equity funds are in a different situation. In the five years ending July 2016, the Russell Global ex-U.S. Index has had an annualized return of 2.3% compared to 13% for the S&P 500. The lower market returns mean many non-U.S. equity funds as a whole lost only 0.95% to taxes for the three years ending June 2016, and many still have CLCFs from 2008/2009.
Unfortunately, those tax offsets may soon be expiring without funds being able to use them up.
Here’s why: The Regulated Investment Company Modernization Act of 2010 changed the tax rules so that any CLCF that occurred in taxable years before December 22, 2010 expires eight years after occurrence while CLCFs that occurred after December 22, 2010 can be carried forward indefinitely. So, CLCFs created in 2008 and 2009 are set to expire in 2016 and 2017. Also, any CLCFs accrued after the new tax rule was enacted must be used before a fund can use CLCFs banked before the rule was enacted in 2008/2009.
If non-U.S. equities see modest returns closer to their long-term average, the amount of capital gains distributed to investors will likely increase and the amount of after-tax return investors receive will decrease. It requires a bit of digging, but mutual funds usually publish a schedule of CLCFs in the annual Statement of Additional Information. For each fund your clients hold, note how much CLCF is expiring and when. Then, compare the size of the expiring CLCF to that of the overall mutual fund. If the expiring CLCF represents a small percentage of the fund’s total AUM, it would only take modest positive market returns to eat through the CLCF.
Don’t wait until after the CLCFs expire before making an investment change. Starting a tax-managed international equity approach before the CLCFs expire may lessen any related tax hit on appreciation of shares from now until the point when you decide to make a tax-managed move. Taking into account a client’s entire portfolio, including any gains or losses, you could consider moving affected investments to funds that are tax-managed by design. You could also consider having clients invest new dollars and reinvest future distributions immediately in a tax-managed approach.
International equities are typically tax inefficient because of poor tax management by money managers. You can help your clients obtain the value of global diversification in their taxable accounts by investing in funds that explicitly seek to manage taxes. A fund that takes a long-term perspective, avoids costly turnover, tilts away from high dividend yielding securities, and systematically harvests losses to offset gains may save your clients a lot of money in taxes and allow them to compound more wealth.