Morningstar’s tax-cost ratios beat its fund rankings

In 1973, Burt Malkiel published the first of what would become nine editions of “A Random Walk Down Wall Street.” He popularized the efficient markets hypothesis, in which stock prices accurately reflect future expectations so that stock-picking mutual funds are unlikely to beat an index strategy.

Empirical studies of mutual funds have repeatedly supported the theory and in turn, have dismissed the notion that past outperformance predicts future outperformance. Yet 44 years later, Morningstar still publishes star rankings, which are based on mutual funds’ past performances.

Recently media outlets have highlighted the star rankings’ inability to predict future performance.

Don’t despair. This doesn’t mean advisers and their clients are without dependable tools to predict how they can boost returns. Investing in funds with lower expense ratios, such as ETFs, certainly helps. Another effective method is to minimize taxes, which, studies by Morningstar and others show, has a significant impact on after-tax returns. So why do clients, and even some advisers, continue to rely on star rankings?

OUTLIER FALLACY

With apologies to Malcolm Gladwell, “the fallacy of outliers” provides an explanation. A corollary of the efficient markets hypothesis is that some of the thousands of funds will have long positive performance and appear to have statistically significant records, which might be counted on to persist. For these funds, the star rankings have been “proven right.”

Alas, these funds still provide “a random walk down Wall Street”, with no expected outperformance in the future. Advisers should tell investors to ignore the siren calls to buy five-star funds—and avoid so-called experts who base their recommendations on them.

(More: Morningstar’s adviser-sold 529 plans: The good, bad and ugly.)

While the star rankings may prove futile, more than a decade ago, Morningstar introduced clearly defined tax-cost ratios. These ratios estimate, on a historical basis, how much return shareholders of a mutual fund lost to taxes on income and gain distributions, and can be used to identify those assets that should be placed in an IRA versus those in a brokerage account.

Most investors have IRAs with deferred taxes and brokerage accounts with current taxes on investment income and capital gains. One way to bolster after-tax returns is “tax-smart asset location,” which places heavily taxed assets in their IRAs and holds lower-taxed assets in brokerage accounts.

For taxable bond funds, these ratios are proportional to historical yields since gains distributions are typically small. Investors with high tax rates can compare taxable bond funds—with yields adjusted for tax ratios—and municipal bond funds to determine their preferred investment in their brokerage accounts. They also can prioritize which bond funds to place in IRAs based on the highest tax ratios and yields.

RATIO FLOOR

Taxes on dividend yields create a floor for Morningstar tax ratios for stock funds. Investors can prioritize placing any high-turnover- and tax-ratio funds in their IRAs. Investors can hold low tax ratio stock funds in their brokerage accounts with one significant caveat: they will have to pay long-term gains if they sell a stock fund purchased at a lower price, after correction for any distributed gains.

Therefore, investors should buy and hold stock funds or individual stocks for years. Those who use this approach will benefit from the delay in paying taxes on realized gains, and often from paying lower rates on capital gains if they have lower earnings in future years. This gives investors another reason to ignore siren calls to substitute high-ranked funds for low-ranked funds.

Statistics on holding periods for stock mutual funds and ETFs suggest that most investors are not delaying gains anywhere near as long as they should. Vanguard has estimated that investors in its stock mutual funds and ETFs had average holding periods of 44 months and 36 months.

Bottom-line advice if you’re using Morningstar as a guide: Ignore the star rankings and anyone recommending its high-ranked funds. Refocus on low-expense ratio funds and minimize taxes by employing a tax-smart asset-location strategy.

The efficient markets hypothesis made a compelling case 44 years ago on a pretax basis for index funds. You can make an equally compelling case for them on an after-tax basis by buying and holding them for a long time.

Now that’s efficient.

Paul Samuelson is the Chief Investment Officer and Co-Founder of LifeYield.