Common Sense on Mutual Funds: Fully Updated 10th Anniversary Edition

Chapter 13. On Taxes: The Message of the Parallax

Often, a small change in vantage point can engender a large change in perception. So it is with the parallax, exemplified by the angle created by the 2½-inch distance between our eyes, which enables us to visualize objects in three dimensions. As I discussed in Chapter 3, mutual fund investment has four dimensions: return, risk, cost, and time. It is conventional to consider investments on the basis of return and risk, but I believe that adding cost as a third dimension provides a far better understanding of investment returns generally, and mutual fund returns in particular. Thus, I apply the principle of the parallax to mutual funds.

The impact of cost is greatly magnified when we consider not only the substantial operating and transaction costs of mutual funds, but the cost of taxes as well. The profound impact of taxes on fund returns is a subject too long ignored. Fund managers may feel that they can afford to ignore it, but fund owners ignore it at their peril. With an estimated $700 billion of capital gains currently on the books in mutual fund portfolios, it is high time for the subject of taxes to receive the exposure it deserves. To be sure, an investor's goal is not simply to minimize the tax burden, but rather to achieve the highest possible net returns. Paradoxically, however, a focus on minimizing taxes seems not only not to diminish, but to enhance pretax returns.

Given the remarkable increase in potential tax liability ...