In the next few weeks, shareholders in the Independence and Great America Funds will be receiving advice regarding capital gains and dividend distributions for the year. The good news is that for both funds, the short- and long-term capital gains distributions will be very low. This is a reflection of our tendency toward long-term share ownership and low turnover, as well as our willingness to engage in tax-loss selling to net some existing losses against recognized gains.¹

Mutual funds differ from stocks in their tax treatment. If you hold an individual stock, you pay capital gains tax when you sell your shares. But with mutual funds, you might owe Uncle Sam even if you don’t make any transactions during the year. According to the Securities and Exchange Commission, more than 2.5% of the average fund’s total return is lost each year to taxes.

Here’s the dirty little secret: Those lists of best- and worst-performing funds that you see being released each December and January rarely take tax efficiency into account. In my own discussions with portfolio managers, I have gotten the distinct impression that we are somewhat out of the ordinary in our determination to minimize the tax drag to our shareholders. Why would the average portfolio manager worry about something on which he or she isn’t judged?

I’ll tell you why I do. Because I’m selfish and cheap. I hate paying taxes if I don’t need to, because every penny I pay in tax is one that can no longer work for me through the magic of compounding (which is why that 2.5% statistic listed above is a much bigger debacle for shareholders than it might seem).

And lest you think this is idle “see, I’m on your side” chatter, please know that I am one of the largest individual investors in Motley Fool Funds, and that our entire portfolio team counts itself as clients. It costs us if we don’t pay attention to things like tax efficiency. According to a 2010 Morningstar study, mutual funds with substantial portfolio manager ownership have historically tended to outperform those whose managers have little or no skin in the game.

Turnover – it’s a great tool in its place
One way to determine roughly how much buying and selling is going on in a fund is the turnover ratio. Many mutual fund managers claim to be long-term investors, yet according to Morningstar (again), the average equity mutual fund’s turnover ratio exceeds 130%. This means that the average holding period for a share of stock in the mutual fund industry is approximately 10 months, not even long enough to get long-term capital gains treatment. To me, a fund manager who tends to hold stocks for such a short length of time isn’t investing, he’s trading. Nothing illegal or immoral about that, but like taxes, trading commissions are paid out in cash and can be costly over time.

I’m not arguing from a position of overwhelming strength here. According to Morningstar (which is pretty much the MVP of this letter), the Motley Fool Independence Fund turnover is 37%. Great America Fund doesn’t yet have a measurement, but we have estimated it internally at about 18%. Our funds’ turnover ratios give some insight as to why it’s a measure that should be used as a heuristic, not an absolute. Turnover ratio doesn’t tell the whole story.

First, the turnover ratio is based on average assets over the year. Both of our funds started the fiscal year with far lower asset bases than they ended it. Great America began with $1 million and ended with $55 million, so the average assets were just shy of $30 million. Obviously, then, trades that we made at the end of the period were much larger as a percentage of average assets than they were for the assets under management at the time we made the trades.

If you think about the mandate of growth funds versus value funds, a growth fund is likely to be more tax efficient even with a higher turnover ratio, since growth investors tend to sell losers, while value funds tend to sell stocks after they’ve appreciated based upon a stricter sales discipline. Further, as we have practiced in our funds, a fund manager who offsets taxable gains by selling losing positions does so at a necessary cost of a higher turnover ratio.

And finally, you should know that we do not manage toward a target turnover ratio. While we do generally believe that lower portfolio churn is better, we will sell any company in our portfolio that has exceeded our fair value estimate without hesitation. Similarly, we are willing to “trade up” in order to gain more exposure to a position we believe has a higher probability of success. A fund chock full of bad bets due to the manager’s desire to keep churn as low as possible is of no particular benefit to shareholders. When the market demands we sell, we will do so.  

What about IRAs?
“Ah,” you ask yourself, “does this turnover discussion apply to me if I hold this or other funds in tax-advantaged accounts like an IRA?” Yes, for two very important reasons. First, even if you aren’t hit with an annual tax bill, you are still exposed to other expenses that you may never see. One direct, unavoidable consequence of heavy trading in a fund is that those commissions and spreads are passed on to shareholders. High turnover may not mean high taxes for you, but it almost always means high transaction costs.

Second, if you own a mutual fund with high turnover, at no point can you have much confidence that you know what’s being held in the portfolio. We launched the Independence Fund in June 2009 and made a symbolic purchase of Yum! Brands as the first shares into the fund. Since that time, we haven’t sold that first share of Yum!, and that holds true for many of the companies we bought the day the Independence Fund opened. If you walk into a KFC or Taco Bell (or Little Sheep Hotpot) at any point in the next few years, it’s reasonable for you to assume that as a Fool Funds shareholder, you’re patronizing a company of which you own a small piece. (Though, I hasten to point out, we make no guarantees this is true at any point).

Another reason why this matters: with such high turnover ratios, fund managers cannot possibly be stewards of good governance. We have a responsibility to vote proxies on your behalf, and at Fool Funds we take this task quite seriously. We even vote proxies on companies that we no longer hold (which happens if you have sold since the day of record for ownership). I believe, with absolute conviction, that it is no coincidence that spiraling corporate salaries and horrid shareholder treatment by public companies have been aided by the low level of oversight by the multitrillion-dollar institutional investor segment’s short-term focus. Why in the world would a super-busy fund manager bother to fight for good corporate governance when he or she is going to hold a company for less than 10 months? Who cares! Just move on to the next thing.

Want an example? In 2008, Chesapeake Energy CEO Aubrey McLendon essentially lost his fortune when he got hit with a margin call (he had borrowed money to buy his own company’s stock, which then tanked). So in 2009, the Chesapeake Energy Board of Directors recommended that McLendon be paid more than $100 million, and further that the company buy art from him for $12 million (there’s more, but you get the idea). The impression that the board was helping McLendon recover from his investing losses was unavoidable. In my opinion, the entire proposal was shameful.

If you’re a long-term investor, this kind of “heads I win, tails I still win” compensation philosophy would give you pause. Maybe you fight it. Maybe – and this is where we fall – you stay far away from a company that would treat shareholder assets in such a manner. Maybe you would further – like us – take note of the names of the members of the Chesapeake Board’s compensation committee (in 2009 it was Frank Keating, Merrill A. Miller, Jr., and Frederick Whittemore) and not only raise your investing hurdle for Chesapeake Energy, but for any other company on whose board they serve.²

If you’re a short-term investor, Chesapeake Energy’s compensation policy isn’t particularly relevant to you. What’s relevant is that the stock might go up in the near term. Meanwhile companies know that they have enough short-attention-span shareholders that they can pay their managers (and directors) whatever they want. That’s costly. Extremely.

We care about this, and you should too. Even if you hold mutual fund shares in a tax-advantaged IRA, you cannot hide from sneaky costs in the form of trading commissions and unchecked power at the underlying companies.

 

 

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