The Importance of Calculating After-Tax Returns

Gus Sauter, former CIO at Vanguard, talks about the need to focus on after-tax investment returns in an interview with the WSJ (found via Abnormal Returns). He answers the question What’s your most important tax advice for mutual-fund investors?:

For equity investors with a long time horizon, it is important to search for funds that have low annual distributions of capital gains. Grinding through the math, it turns out that a fund that realizes and distributes most of its capital gains annually would have to outperform a fund that distributes minimal capital gains by as much as 2% per year in order to provide the same long-term, after-tax return. Funds that have lower turnover are a pretty good place to start looking for low capital-gain distributions. Index funds are an obvious candidate.

For fixed-income investors in higher tax brackets, municipal-bond funds can be an attractive alternative to taxable bond funds.

In 2013, many successful active funds that trade frequently (high turnover) distributed sizable capital gains. Resources like Morningstar.com can provide information about turnover ratio and after-tax returns for specific funds.

Here are the 2013 capital gains distributions for all Vanguard funds. Both Vanguard’s Total US Stock and Total International Stock funds distributed zero capital gains for 2013. For your own holdings, you can check your tax statements to compare the relative size of the capital gains with the share price (NAV).