Tax and your investment returns

Recently, finance professor Moshe Milevsky published his research on how personal income taxes affect the returns and rankings of Canadian equity mutual funds. Any Canadian with money invested outside their RRSP should be conscious of his findings.

The importance of after tax returns

If we had two investments, one offering a 10% return and the second offering an 8% return, which would you choose? This is not a trick question. Most of us would choose the 10% investment, all else being equal. However, if the first investment produced an after-tax return of 6% while the second produced a return of 7%, which would you choose now?

The old saying goes, "It's not what you make but rather what you keep that counts." This is especially true with investments. Consider that two-thirds of all investable wealth in Canada is outside of registered plans like RRSPs. In the Canadian mutual fund industry, 54% of the assets — almost $200 billion — are held outside of RRSPs. Add to that the impending trillion-dollar transfer of wealth through inheritance and you've got a strong case for after-tax investment awareness.

How much is lost to taxes?

Milevsky, an asssociate professor of finance at York University's Schulich School of Business, concludes that, on average, 1.35% is lost to taxes from annual distributions alone. Before tax, the average annual return for mutual funds with a 10-year history (343 funds) was 9.01% percent. After distributions, the average return dropped to 7.66%.

Furthermore, tax is triggered not only by the fund manager's activities, but also when investors dispose of the funds. On average, an investor disposing of a fund stands to lose another 1.0%.

Understanding tax efficiency

In technical terms, the average tax efficiency was about 85% based on the fund manager's activities within the fund. An 85% tax efficiency ratio simply means that the investor got to keep about 85% of the pre-tax return; the other 15% went to taxes.

In Milevsky's research, the highest tax efficiency ratios were 100% before disposition by the investor. Only 54 of 343 funds achieved this highest distinction.

On the flip side, the worst tax efficiency ratio was 25.31% — investors got to keep only about 25% of the pre-tax returns, with the other 75% going to taxes.

Ranking the results

When Milevsky compared the performance of 343 mutual funds before taxes with their performance after taxes, the results were astounding. Fifty percent of the funds moved more than 19 positions from their pre-tax returns to their after-tax returns. For example, the biggest change occurred with the Montrusco Bolton US Index Fund, which had the 66th best performance before tax. When taxable distributions were taken into account, this fund dropped 185 positions to 251st.

According to this study, the fund with the best pre-tax return was the Multiple Opportunities Fund (21.58%). However, on an after-tax basis, it ranked fourth overall with a still respectable 14.45% return.

The funds with the three best after-tax returns were the Formula Growth Fund, the AIC Advantage Fund and the Maestral Quebec Growth Fund.

The bottom line

If you are looking to invest non-RRSP money, you must be aware of the implications of tax. The biggest problem in the industry today is that it posts pre-tax returns and not after-tax returns. This may change one day, but for now the information available about the tax efficiency of funds is limited.

Some financial advisors can access tax efficiency data through PalTrak by Morningstar, but caution is advised as there are still some inconsistencies with the data.

For retail investors, this information is almost impossible to find. Until the regulators make after-tax disclosures mandatory, access to this information will remain limited.

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Jim Yih is author of Mutual Fundamentals and Seven Strategies to Guarantee Your Investments. He is the founder of CORE Financial Advisors and Account Representative of Manulife Securities International Ltd. Commissions. Jim can be reached through his Web sites Wealthweb.ca, Retirehappy.ca, COREFinancial.ca and JimYih.com.