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If you unfamiliar with the financial term Tax Cost Ratio (TCR,) you aren’t alone. TCR refers to the amount a fund’s annualized return is reduced by taxes because of distributions (including stock and bond dividends and capital gains distributions).

If a fund has a one-year tax cost ratio 0.9%, it means an investor’s returns were reduced by 0.9% during that year by dividends, interest, capital gains distributions, or a combination of the three.

TCRs are somewhat irrelevant in tax-deferred and Roth accounts because you aren’t taxed annually on the money in those accounts. You either pay taxes when you take distributions or you’re taxed when you make contributions. However, you should be aware of TCRs in taxable accounts.

I wanted to see how much an investor’s return would be reduced by taxes when owning a mutual fund (MF) versus an Exchange Traded Fund (ETF) in a taxable account. In this hypothetical illustration, I picked a mutual fund and an ETF based on asset size. Here’s what I found:

Tax Cost Ratio over rolling time periods

By design, certain ETFs are more tax efficient than mutual funds, so it wasn’t surprising to see it with a lower TCR in all periods. After determining the rolling TCRs for 1-, 3-, 5-, and 10-years, I wanted to see the impact they would have on a $1 million taxable account. To compare similar products, I used a 6% compounding return for the MF and ETF. I then subtracted the TCR from the rolling time periods to see the values at the end of each time period:

Returns reduced by the investment’s Tax Cost Ratio

Finally, I wanted to see the TCR in dollars between owning an ETF versus a MF in a taxable account:

Tax Cost Ratio saving difference by owning an hypothetical EFT versus a mutual fund

Tax Efficiency

Tax efficiency shouldn’t be the only consideration when making investment decisions, but it should be one of them. If you have retirement accounts and taxable accounts, it probably makes sense to hold tax-inefficient assets like mutual funds with high turnover, active mutual funds, bond funds, and balanced funds in retirement accounts. Then your taxable accounts can hold investments that are more tax efficient like index funds, individual stocks, and tax-managed stock-based mutual funds.

If you think about the MF in a taxable account having a TCR of 1.39% over 10 years, an internal expense ratio of .65%, and inflation averaging 1.73%; a 10-year annualized return of 13% is really a 9.23% return.

One last example of the importance of “it’s not about what you make, it’s about what you keep”. Playing Monday morning quarterback and without understanding TCRs, on paper you’d rather own the MF over a 20-year time period because its annualized return was 7.56% compared to the ETF’s 6.64%. That’s an out-performance of 18.4% over 20 years. But, when you factor in the TCRs, expense ratios, and a 20-year inflation average of 2.17%, the ETF actually outperformed the MF.

Annualized returns versus actual returns

Final Thoughts

Will someone own $1 million dollars in a single mutual fund or ETF? Hopefully not. But a diversified mutual fund or ETF portfolio won’t necessarily reduce or fix the TCR problem. In fact, bond funds and bond ETFs can have a higher TCR than their stock counterparts. In doing my research I found an Intermediate-Term Bond ETF’s 1-, 3-, and 5-year TCR is higher, by almost double, when compared to an all stock-based EFT. Bottom line, it’s important to spend some time understanding what you own and where you own it. Making the right choice could save you tens if not hundreds of thousands of dollars in the long run.

Disclosures

investors should carefully consider the investment objectives, risks, charges and expenses of mutual funds and exchange traded products carefully before investing. The prospectus contains this and other information and should be read carefully before investing. The prospectus is available from our office or the fund company and should be rad carefully. Every type of investment, including mutual funds, involves risk. Changing market conditions can create fluctuations in the value of a mutual fund investment. In addition, there are fees and expenses associated with investing in mutual funds that do not usually occur when purchasing individual securities directly.
These calculations are hypothetical examples used for illustrative purposes and do not represent the performance of any specific investment or product. Rates of return will vary over time, particularly for long term investments. Actual results will vary.