Morningstar Tax Cost Ratio Research Paper
The Morningstar Tax Cost Ratio measures how much a fund�s annualized return is reduced by the taxes investors pay on distributions. Mutual funds regularly distribute stock dividends, bond dividends and capital gains to their shareholders. Investors then must pay taxes on those distributions during the year they were received.
Like an expense ratio, the tax cost ratio is a measure of how one factor can negatively impact performance. Also like an expense ratio, it is usually concentrated in the range of 0-5%. 0% indicates that the fund had no taxable distributions and 5% indicates that the fund was less tax efficient.
For example, if a fund had a 2% tax cost ratio for the three-year time period, it means that on average each year, investors in that fund lost 2% of their assets to taxes. If the fund had a three-year annualized pre-tax return of 10%, an investor in the fund took home about 8% on an after-tax basis. (Because the returns are compounded, the after-tax return is actually 7.8%.)
The tax cost ratio provides additional information that is not available from after-tax returns alone.
Per the SEC�s guidance, after-tax returns reflect both tax effects and sales loads. The tax cost ratio isolates the effects of taxes alone.
Different categories of funds and different time periods will have varying levels of pre- and after-tax returns. The tax cost ratio is independent of the level of the return and it is always expressed on an annualized basis. Therefore, it can be used to compare different funds, categories, managers, and time periods. For example, you can compare the three-year and 10-year tax cost ratios for the same fund to see if the manager has become better at managing tax issues in more recent years.
Morningstar calculates the tax cost ratio in-house on a monthly basis, using load-adjusted and tax-adjusted returns for different time periods. Morningstar uses the tax-adjusted return that is called �pre-liquidation after-tax return,� which is also known as �return after taxes on distributions.� Morningstar calculates this statistic for open-end mutual funds, exchange-traded funds, and variable annuity underlying funds based in the United States.
Because the tax cost ratio is based on after-tax returns, it is based on the same assumptions as those returns and it is an estimate of what the hypothetical investor would experience. For example, after-tax returns assume that investors pay the maximum federal tax rate on capital gains and ordinary income.
The tax cost ratio for time i, Ti, is
Ti = 1 - (1 + ATRi)/(1 + Li)
where
ATRi = annualized pre-liquidation after-tax return for the time period i. (This is also load-adjusted.)
Li = annualized load-adjusted pre-tax return for the time period i
The tax cost ratio is a positive expression of a negative rate of return that is due to taxes. By rewriting the equation, it is apparent that the after-tax return is the same as compounding the load-adjusted return and the tax cost ratio negative return.
(1 + ATRi) = (1 + Li)(1 - Ti)
(1 + after-tax return) = (1 + load-adjusted return) (1 + negative rate of return for taxes, i.e. �tax cost ratio)
The tax cost ratio measures the percent of assets that an investor paid in taxes. For example, an initial investment of $100 will grow to $115 with a load-adjusted return of 15% and will grow to $112 with a tax- and load-adjusted return of 12%. The tax cost ratio is (dollars paid in taxes)/(ending value) = $3/$115 = 2.61%. This is equivalent to the original formula 1-(1.12/1.15)=2.61%. This fund had a 15% load-adjusted return and a �2.61% negative return for taxes. The product of these two returns is the 12% tax- (and load-) adjusted return.
Morningstar Tax Cost Ratio Research Paper