Listed for three, five, 10, and 15 years, this statistic (which excludes additional gains, taxes, or tax losses incurred upon selling a fund) represents the percentage-point reduction in an annualized return that results from income taxes. The calculation assumes investors pay the maximum federal rate on capital gains and ordinary income.
The tax-cost ratio, like an expense ratio, is a measure of how one factor can drag down performance. The distribution of the tax cost ratio is rated on a low percentage scale with most funds in the range of 0-10 but often concentrated in the range of 0-5. In the range of 0-5, 0 indicates that the fund incurs no taxes or very little taxes and 5 indicates that the fund is less tax efficient.
Benefit
Tax cost ratio provides a contrast to historical returns after taxes. While the latter measures the bottom-line aftertax results of a fund without regard to pretax performance, tax-cost ratio measures whether the fund manager has kept an eye on tax consequences.
This data point is directly comparable to the fund's operating expense ratio, and can be used to determine whether the taxes or expenses had a larger impact on net returns. The tax-cost ratio can also be used to compare the tax consequences of two funds over a specific period of time.
Origin
Morningstar generates this figure in-house, by dividing the aftertax (or tax-adjusted) return of a fund by its pretax return.
Example
If a fund made short-term capital-gains and income distributions that averaged 10% of its NAV over the past three years, an investor in the 35% tax bracket would have a tax cost ratio of 3.5 percentage points. (The 35% tax rate was used for illustrative purposes because, according to current tax law, the maximum income-tax rate will fall to that level. However, our tax-cost calculation uses the maximum income-tax rate that applied during the year in which the distribution was made.)
For the Pros
This methodology allows us to calculate the tax efficiency for all funds.
Formula
The Tax-Cost Ratio for time period t (TCRt) can be calculated as follows:
Where:
TRt = the annualized load-adjusted total (pretax) return for time period t
TRATPL,t = the annualized total net SEC after-tax return (pre-liquidation) for time period t
Example 1
Suppose the annualized total return and SEC-after-tax (pre-liquidation) return from November 2000 to October 2001 are 10% and 8%, respectively. Then:
TCR = 1 - [(1 + 0.08)/(1 + 0.10)] = 1.8%
Example 2
Suppose the total return and SEC-after-tax (pre-liquidation) return from November 1998 to October 2001 are 5% and 2%, respectively. Then:
TCR = 1 - [(1 + 0.02 )/(1 + 0.05)] = 2.9%