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After-tax returns are what matter to fund investors

Some things just don't make sense to me. My wife has a woman come over once a week to do the cleaning, so that she's freed up to volunteer at a day-care centre, where our cleaning lady sends her kids.

Now, let me get this straight. We pay the cleaning lady $80 each week, and it costs her $80 each week to send her kids to the day-care.

So, our cleaning lady breaks even, we're out of pocket $80, and the day-care owner makes $80. I've got a better idea. Why don't we just clean our own home, let the cleaning lady look after her own kids, and I'll just send a cheque for $80 to the day-care owner each week. We'll accomplish the same thing, but my wife will save gasoline costs. Clever eh?

You know, Canadian investors can sometimes be accused of investing their money in a manner that makes about as much sense as our house-cleaning arrangement. That is, it makes no sense at all. I'm talking about investors who fail to consider the impact that taxes can have on a portfolio over time.

The research

On April 8, the results of research sponsored by AIC Ltd., and headed-up by professor Moshe Milevsky from the Schulich School of Business at York University, revealed some interesting facts about taxes and investing in mutual funds.

The study examined more than 340 Canadian-managed equity and balanced mutual funds that had a track record over the period 1991 to 2001. The average rate of return on those funds over that time was 9.01 per cent compounded annually, before taxes. But you've got to realize that many of those funds made taxable distributions over that 10-year period. In fact, the average fund lost a full 1.35 per cent, compounded annually, to income tax on distributions alone (assuming the highest tax bracket), with the result that the true rate of return, after taxes, was just 7.66 per cent when investing outside of a registered plan.

If you had liquidated the average mutual fund at the end of the 10-year period, you would have lost an additional 1 per cent annually to taxes as a result of the taxable capital gain on liquidation. This would have reduced your post-liquidation after-tax return to just 6.66 per cent annually.

At the extreme end of the tax-inefficiency scale, the top ranked fund on a pretax basis -- the Multiple Opportunities Fund -- lost 7.13 per cent annually to income taxes, moving it from first place to 16th. Another fund -- Montrusco Bolton U.S. Index Fund -- moved a whopping 185 spots down the list, from position 66 to 251, after taxes.

The research demonstrates that there is a nearly 50-per-cent likelihood that two funds ranked in close proximity to each other on a pretax basis will actually reverse their rankings on an after-tax basis.

The top two funds on an after-tax basis were the Formula Growth Fund, and the AIC Advantage Fund, neither of which made taxable distributions over the 10 years.

The implications

What does all of this mean for the average investor?

If you compare the returns of one fund with another to make your investment decisions, and you're investing outside of your registered retirement savings plan, registered retirement income fund or registered education savings plan, you better take a look at the after-tax figures, not the pretax figures. The problem? The after-tax figures are not readily available in Canada. Well, not yet.

In the United States they've got it right. On Jan. 19, 2001, the U.S. Securities and Exchange Commission announced it had adopted rules requiring mutual funds to disclose standardized after-tax returns. We can only hope that the securities regulators in Canada eventually take the same common sense approach. In the meantime, don't hesitate to ask your fund company to disclose their after-tax returns -- a number of fund companies agree that this disclosure makes sense.

It's interesting that the tax bite resulting from the taxable distributions annually over the 10-year period (1.35 per cent) was greater than the tax bite resulting from liquidation at the end of the 10-year period (1 per cent). What does this mean? That mutual fund managers have a profound impact on the level of tax you'll pay over time. So choose your managers wisely; some are more tax-efficient than others -- particularly buy-and-hold mangers.

Above all, make sure you understand the attitude of the fund company and the fund manager toward tax efficiency. Many fund mangers grew up in the pension industry where assets are tax-sheltered, and were never taught that taxes matter. But if you're investing outside a registered plan, you need to care about taxes -- and so should your fund manager.

Tim Cestnick, CA, CFP, TEP is author of The Tax Freedom Zone and Winning the Tax Game 2003. He is managing director, National Tax Services, at AIC Ltd. tcestnick@aic.com



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