Morningstar - Q3 2024 - 33

Active Funds Try to Raise Their Game
Portfolio managers finally incorporate tax
management into their process.
TAX MANAGEMENT
Russel Kinnel
On a recent visit to Fidelity in Boston, I was
struck by how many equity portfolio managers
mentioned tax management as part of their
investment process.
It's a sensible thing for them to do and not hard
to guess why they're doing it. Stock exchangetraded
funds are taking market share from
actively managed equity open-end funds. Part of
the appeal of ETFs is that they manage taxes
better than the typical open-end active fund. There
are two reasons. First, ETFs' structure helps them
avoid distributing capital gains. Second, most
ETF money is in passive, low-turnover strategies
that usually generate little capital gains.
Historically, open-end active funds have been all
over the map when it comes to taxes. Some
managers were very aware of their funds' tax
situations and took pains to manage for maximum
aftertax returns. Others paid little attention
to taxes, partly because their clients mostly owned
their funds in tax-sheltered accounts and partly
because fund managers' bonuses were based on
pretax returns versus their benchmarks.
Tax-management techniques include selling
the highest-cost lots, or those with the smallest
accumulated capital gains, first; holding
appreciated shares for at least a year, after which
they qualify for the lower-tax long-term
capital gains rate; and reducing turnover. These
tactics don't help investors in tax-sheltered
accounts, but there are managers who go
further and factor the tax bill for selling an old
holding into their estimate of the potential
return of a new holding. At this point, a manager
is prioritizing aftertax returns over pretax.
Most managers stop short of that point, including
the ones I met with at Fidelity.
Some factors are out of a manager's control.
Bull and bear markets have big impacts since
they can lead to big gains or big losses. Also, fund
flows are crucial. Big inflows reduce the tax
burden by spreading distributions across more
investors. Conversely, outflows can force
managers to sell to meet redemptions, realizing
capital gains that their funds must distribute
across fewer investors. Thus, funds' tax
profiles can change with market environments.
Understanding Aftertax Returns
An investor's bottom line is aftertax returns,
not minimizing taxes. A fund that triples
in 10 years will give investors bigger tax bills than
one that appreciates only 10% over that span,
but its aftertax returns will probably still be
larger. To better understand the issue, I looked at
11 big fund companies' equity fund returns on
an aftertax basis.
To get aftertax returns, I took fund returns,
subtracted any front loads, and calculated
appropriate tax rates for income, shortterm
gains, and long-term gains, assuming the
highest tax rate at the time of the distribution.
I then calculated the remaining return,
percentile `rank` within the Morningstar Category,
and tax-cost ratio, which is like an expense
ratio for taxes-an annualized figure
reflecting the difference between pretax and
aftertax returns.
EXHIBIT 1
DFA and Fidelity Most Tax-Friendly The charts show the percentile ranking for
equity funds of the fund families on a five-year aftertax basis. DFA is at the top for
all funds. If we exclude passive funds, Fidelity leads.
Active and Passive
Fund Company
DFA
Fidelity
Vanguard
Artisan
Janus
BlackRock
T. Rowe Price
Franklin
American Century
MFS
20
40
Aftertax Return Percentile
Category `rank`, 5-Yr
30
32
37
40
44
44
47
48
50
51
60
Active
Fund Company
Fidelity
Vanguard
Artisan
Janus
BlackRock
T. Rowe Price
Franklin
American Century
American Funds
MFS
20
Source: Morningstar. Data as of March 31, 2024. All DFA funds are passive, which is why the firm isn't included in the Active list.
40
Aftertax Return Percentile
Category `rank`, 5-Yr
29
40
40
44
45
48
48
50
51
52
60
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