Page 1



Copyright Š 2012 by Institute of Business & Finance. All rights reserved.



AFTER-TAX RETURNS The next table shows returns before and after taxes for index funds. It is assumed that all distributions are taxed at a 35% tax rate; it is also assumed that the investor does not sell any shares. The return figures shown in parentheses are after-tax returns. As you can see, tax efficiency is dramatically higher than what the financial press implies.

Index Mutual Funds: Before and After-Tax Returns [all periods ending 12-31-2006] Index Fund

1 Year

5 Years

10 Years

15.5% (15.2%)

3.4% (7.4%)

7.1% (8.1%)

9.0% (8.9%)

3.4% (7.1%)

7.1% (8.8%)


22.1% (21.7%)

9.5% (9.1%)

9.5% (8.1%)

Small Cap Value

19.2% (18.8%)

13.0% (12.3%)

10.2% (8.9%)

Small Cap Growth

11.9% (11.9%)

11.2% (11.2%)

8.1% (7.9%)

Small Cap

15.6% (15.4%)

11.6% (11.3%)

10.0% (8.8%)

Mid Cap

13.6% (13.4%)

12.3% (12.0%)

11.8% (10.7%)


35.1% (33.6%)

22.7% (20.7%)

14.2% (12.0%)

Total U.S. Market Growth

TURNOVER AND TAX EFFICIENCY The financial press emphasizes the “connection” between a mutual fund’s turnover rate and its after-tax returns. The belief is that the higher the turnover, the less tax efficient the fund. The discussion never includes the fact that the sale of losing securities can offset realized gains, dollar for dollar. The reality is that mutual fund can have quite a bit of selling activity that generates tax losses that may offset some, most, or all of the securities sold for a profit. Equally important, large gains may be due to securities in the portfolio that have enjoyed substantial appreciation but are still owned by the fund. Such paper profits are not taxed since no gain (or loss) has yet been realized. The table below shows turnover and tax efficiency for a handful of equity mutual funds; performance figures and rankings are through the end of February 2007. All of the funds shown are either mid or large cap growth, value, or blend. As you can see, a fund can have very high turnover and still be extremely tax efficient. PART IV




For example, over the past five years, Eaton Vance Growth A averaged 10.60% per year before taxes and 10.53% after taxes (the rate assumes the investor did not sell his or her shares). Even though this fund experienced an annual turnover rate of 208%, its tax efficiency was quite a bit higher than what is considered a tax efficient fund, Vanguard 500 Index, which had an annual tax cost that was five times greater than the Eaton Vance fund (0.36 vs. 0.07%).

Annual Turnover vs. Tax Efficiency Annual Turnover

Annual Tax Cost

5-Year Return

Category Ranking

Amer. Century Heritagel




top 23%

Aston/Veredus Select Gr.




top 9%

Eaton Vance Growth A




top 24%

Fidelity Large Cap Value




top 17%

Wells Fargo Adv. Gr. Inv.




top 11%




top 42%

Fund Name

Vanguard 500 Index*

*The Vanguard 500 Index Fund is one of the largest domestic equity funds. For the 2010 calendar year, it had a total return of 14.91% before taxes and 14.60% on an after-tax basis, assuming the highest federal income tax rate. This represents a tax efficiency of 98% for 2010.

SYSTEMATIC WITHDRAWAL PLAN A Systematic Withdrawal Plan (SWP) is one of the most powerful tools that can be utilized by the advisor on behalf of the client. A SWP provides the investor with periodic income. The income is generated from the sale of mutual fund shares. In the case of equity funds, share liquidation after the first year of ownership is tax-advantaged (maximum 5-15% long-term capital gains rate). There is no cost in establishing, terminating, amending, or restarting a SWP. One of the benefits of a SWP is that it allows complete flexibility when it is being set up and on an ongoing basis. The investor is not locked into anything. At any time, the dollar amount can be increased or decreased.

Mutual Fund Illustration The following hypothetical uses the growth and income fund, The Investment Company of America (ICA). This fund is used for three reasons: [1] = lengthy track record, [2] lower-than-average risk level (0.9 beta vs. 1.0 for the S&P 500) and [3] it is managed by one of the most popular fund companies (The American Funds Group). The figures below assume a one-time commission charge of 3.5%. The average annualized return for the 77-year period (1/1/1934 through 12/31/2010) was 12.1%. PART IV




1934-2010 Systematic Withdrawal Plan using ICA $100,000 one-time investment; 8% initial annual withdrawal Year

Annual Withdrawal

Remaining Balance


Annual Withdrawal

Remaining Balance






$2.9 million






$5.9 million






$13.4 million






$25.1 million






$49.2 million






$155 million



$1.0 million



$150 million



$1.9 million



$191 million



$2.5 million



$200 million

The illustration above assumes a one-time investment of $100,000, with all dividends and capital gains automatically reinvested each year. A sales charge of 3.50% is initially subtracted from the investment (leaving $96,500 going into the fund). After the first year of withdrawals (1934), the $8,000 annual withdrawal is increased each year by 3% to offset the effects of inflation (e.g., $8,000 the 1st year, $8,240 the 2nd year, etc.). When viewing the hypothetical, keep in mind: 1. The cumulative annual withdrawals total over $2.2 million (remember: only $100,000 was invested). 2. After taking out $2.2 million, the investor still has over $200 million. 3. Compounding over 77 years is dramatic even at lower rates. 4. It is extremely doubtful any person or institution would have stuck with a buy-and-hold strategy for such an extensive period of time (-35% in 2008, -14% in 2002, -17% in 1973 and -18% in 1974). 5. The results would be even higher if a 3.5% commission was not deducted (also higher if a more aggressive fund were used). 6. Only a small number of mutual funds have been in existence since 1934 and most of them cannot match the record of ICA. 7. After the first year, a very high percentage of the withdrawals represent capital gains, taxed at a rate lower than traditional interest-bearing instruments such as bonds, CDs and money market accounts. 8. The starting point or use of a different fund can make a huge difference in the overall results (see S&P 500 example). PART IV




S&P 500 Illustration Going Back to 1934 Using the S&P 500 for the same illustration (see previous page) produces radically different results: [1] the account is completely depleted by December 1956, [2] a cumulative $402,200 is withdrawn (starting with $8,000 taken out in 1934), [3] the net amount invested is $100,000 (not $96,500 as used in the ICA example), [4] the average annual return is 10.0% (until the account has a zero balance at the end of 1956). There is a radical difference between 10% and 12.1% annualized over a multiple-decade period.

S&P 500 Illustration Going Back to 1950 For the income-oriented investor, using a growth and income fund as a source of regular income can make a lot of sense. The following example shows what would have happened had an investor been able to invest $100,000 in the S&P 500, with all dividends and capital gains reinvested. If it were a mutual fund, the S&P 500 would fall under the heading, “growth and income.� The real surprise of this illustration is how much growth there is, even after taking out $8,000+ a year. The example assumes that after year one, the annual withdrawal is increased by 3% annually (e.g., $8,000 the first year, $8,240 the second year, $8,490 the third year, etc.). The period covered is 1/1950 through 12/31/2010.

1950-2010 Systematic Withdrawal Plan using S&P 500 $100,000 one-time investment; 8% initial annual withdrawal Year

Annual Withdrawal

Remaining Balance


Annual Withdrawal

Remaining Balance






$1.8 million






$3.1 million






$5.4 million






$14.7 million






$14.9 million






$14.3 million






$16.4 million

For the period January 1st, 1950 through the end of 2010, the S&P 500 had an average annual total return of 12.8%. An investor taking out $8,000 the first year and then increasing the annual withdrawal by 3% thereafter would have taken a total of $1.3 million and still had a remaining balance of $16.4 million by 12/31/2010 (vs. $29.5 million for ICA). Remember, the S&P 500 and ICA investor each made a 1-time investment of $100,000 on January 1st, 1950.





Client Understanding The following is a list of topics and/or concepts that the advisor should make sure the investor understands about SWPs: 1. Few investors actually experience market returns. 2. Average annual returns are different from year-by-year returns. 3. The effect of compounding over long periods of time often results in numbers that seem too good to be true (and are). 4. Despite what most investors say, few are actually “long term” and still fewer will stay the course for 5-10 years or more. 5. Whatever is projected, reality will most likely be quite different. 6. The tax benefits kicks in after the first 12 months, when gains become long-term. 7. The one positive part of principal erosion is that any liquidations of principal are not taxed (you are never taxed on return of principal).

GROWTH VS. VALUE There is no universal definition to value investing. How a manager defines value will determine what is in the portfolio and, ultimately, the fund’s performance. The two major types of value investing are relative-value and absolute-value. A relative-value investor compares a stock’s price ratios (e.g., P/E, P/B and price-to-sales) with a category benchmark and then makes a decision about the future prospects. In general, relative-value funds have a decent shot of delivering strong performance in a variety of market conditions—not just when truly cheap stocks are in demand. The key drawback to the relative-value approach is that these funds might also have more exposure to volatile sectors, with technology and telecom being the prime examples. The “absolute value” approach values the entire company, using things such as its assets, balance sheet, cash flow, and expected future earnings. Managers who practice the absolute value method will also look at what private investors have paid for similar companies. Absolute-value managers do not compare a stock’s price ratios to that company’s historic norms, those of other companies, or the market.





Whether the fund is relative-value or absolute-value based, the average price multiples of the portfolio will show if the manager is acquiring stocks that are more or less expensive than other offerings in the category. Average price multiples can be found in shareholder reports. Although value funds generally show less volatility than growth funds, this does not guarantee safety. In many previous market downturns, such as the cyclicals and financials decline of 1990, the utilities debacle of 1994, and the Asian crisis of summer 1998, value funds lost as much or more money than growth funds. Value managers want to buy stocks that are viewed as cheap or inexpensive, relative to the corporation’s current valuation or by some other measurement. Growth managers interest lies in a company’s earnings, revenues, and/or the potential for the stock’s price to appreciate. A growth manager is usually not expecting any kind of bargain. The companies they seek have higher P/E and P/B ratios than their value peers. Most growth fund managers are earnings-driven; this means that the corporation’s earnings are used as the main measurement for growth. Within the earnings-driven camp are “momentum” managers who are considered the most aggressive of their peer group. You might say their mantra is “Buy high, sell higher.” Momentum investors buy rapidly growing companies they believe are capable of delivering an earning’s “surprise,” such as higher-than-expected profits or other favorable news that will drive the stock’s price higher. A momentum-driven manager tries to buy a stock just before its positive earnings announcement; these same managers hope to sell the same stock just before it misses analyst estimates or before a release of bad news. This type of discipline tends to have very large turnover rates and price multiples that are high or ultra-high. Momentum managers care little, if any, about a stock’s current price. The key problem with earnings-momentum funds is that most investors have trouble sticking with them through the rough stretches. That is why earnings-momentum funds may not serve as worthy core holdings for most investors. In one study, with nine out of 10 major momentum funds, investors’ actual returns were significantly lower than the funds’ reported performance figures would suggest. If you are going to buy a momentum fund, make sure you can stomach significant downturns. Following a disciplined dollar-cost averaging strategy is one way to smooth out some of the bumps that come with the momentum territory plus helps to avoid jumping in and bailing out at exactly the wrong times.





Client Understanding The table below shows cumulative returns of a $10,000 investment in six different stock categories (small cap value, small cap growth, mid cap value, mid cap growth, large cap value and large cap growth) made at the beginning of 1969. Adding up cumulative returns of growth versus value from 1969-2010, value has dramatically outperformed growth; large value outperformed large growth by ~2-1, almost 4-1 in the case of mid cap value vs. mid cap growth and over 10-1 in the case of small cap value vs. small cap growth.

Growth of $10,000 from 1969 to the end of 2010 SC SC LC LC MC MC Value Growth Value Growth Value Growth $3,514,000 $322,000 $1,557,000 $407,000 $545,000 $297,000 From the beginning of 1928 through 2010, $10,000 invested in small cap value stocks grew to $590,172,700 versus $14,757,900 for small cap growth stocks (a margin of 40 to 1). The same dollar invested in large cap value stocks grew to $63,848,100 versus $10,781,800 for large cap growth stocks (margin of 6 to 1). Surprisingly, from 1928 through 2010, the standard deviation for small cap value stocks was only slightly lower than it was for small cap growth stocks; large cap growth stocks had less risk (20% std. dev.) than large cap value stocks (28% std. dev.).





THINGS TO DO  Your Practice Contact a high-end or respected clothing store (e.g., Neiman Marcus, Nordstrom’s, etc.) and ask about putting on a private showing of new clothes with your clients.  The Next Installment Your next installment, Part V, will cover six topics: fund selection, manager ownership, management experience, municipal bond default rates, closed-end muni portfolios and cushioning against stock declines. You will receive Part V in a week.  Learn Are you ready to take your practice to the next level? Contact the Institute of Business & Finance (IBF) to learn about one of its five designations: o o o o o

Annuities – Certified Annuity Specialist® (CAS®) Mutual Funds – Certified Fund Specialist® (CFS®) Estate Planning – Certified Estate and Trust Specialist™ (CES™) Retirement Income – Certified Income Specialist™ (CIS™) Taxes – Certified Tax Specialist™ (CTS™)

IBF also offers the Master of Science in Financial Services (MSFS) graduate degree. For more information, phone (800) 848-2029 or e-mail



Mini-Course Series - Mutual Funds (Part 4)  

The information included in the "Mini-Course Series - Mutual Funds" is representative of the Institute of Business & Finance materials used...

Mini-Course Series - Mutual Funds (Part 4)  

The information included in the "Mini-Course Series - Mutual Funds" is representative of the Institute of Business & Finance materials used...