The Hidden Impact of Taxes on Investment Returns

Published by Marshall Smith, CIPM, Managing Director - General Manager, Products
January 5th, 2015

04-26-10-Uncle_Sam-2If you are not a weekly reader of Jason Zweig’s “The Intelligent Investor” column in the Wall Street Journal, you need to be.  In last week’s article, When Funds Insult Their Investors, Jason illuminated that taxes can be a significant drag on investment returns. If you are investing in taxable accounts, such as a brokerage or professional managed non-retirement account and it contains mutual funds, then in the past few weeks you have likely received a number of capital gain transactions.  These transactions, which can be long or short-term gains for tax purposes, are the result of the funds selling stocks at a gain and, to satisfy Uncle Sam, pass those profits right on to you the patriotic taxpayer.

Jason gives an example of the Calamos Growth fund which distributed $10.13 per share in long-term capital gains.  The net asset value as of last week was $49.72 per share.  The $10.13 gain would then be taxed at the federal and potentially state/local level.  If you are lucky enough to live in Texas, (yes that is a true statement supported by objective facts) then you only owe Federal taxes which would amount to $1.52.  Applying this tax burden at a net asset value of $49.72 per share value, the cost of this distribution is 305 basis points due to taxes!  Forget the 126 basis point expense ratio for the fund, you are paying more than 2 times that in taxes!

This example illustrates the importance of knowing the real return an investor yields from their investments’ net of management fees AND taxes (Note: A “true” real return also subtracts inflation but I’ll leave this for another blog post). There isn’t a significant hurdle blocking investment managers from providing net of fee and tax returns to their clients.  The leading performance and client reporting software solutions utilized by investment managers have included this functionality for more than a decade.  The Global Investment Performance Standards (GIPS) includes several guidance statements on the calculation and presentation of after-tax return that can help if you are unsure how to proceed as an investment manager.

About the Author: Marshall Smith CIPM, Managing Director of Service Bureau, has been with First Rate since 2006. In this role he oversees Service Bureau, the business line responsible for clients that outsource their performance processing function, develops and maintains client relationships, and develops strategic planning for all Service Bureau operations. In addition, he leads First Rate’s Marketing team. You can follow Marshall on Twitter @1stRateMarshall, or connect via LinkedIn.

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