Investments, tenth edition

 Table 4.2 

 Impact of costs on investment 

performance 

Cumulative Proceeds

(All Dividends Reinvested)

Fund A

Fund B

Fund C

Initial investment*

$10,000

$10,000

$  9,200

 5 years

17,234

16,474

15,502

10 years

29,699

27,141

26,123

15 years

51,183

44,713

44,018

20 years

88,206

73,662

74,173

   * After front-end load, if any. 

 Notes: 

  1.  Fund A is no-load with .5% expense ratio.  

  2.  Fund B is no-load with 1.5% expense ratio.  

  3.  Fund C has an 8% load on purchases and a 1% expense ratio.  

  4.  Gross return on all funds is 12% per year before expenses.     

 The Equity Fund sells Class A shares with a front-end load of 4% and Class B shares with 12b-1 fees of 

.5% annually as well as back-end load fees that start at 5% and fall by 1% for each full year the investor 

holds the portfolio (until the fifth year). Assume the rate of return on the fund portfolio net of operating 

expenses is 10% annually. What will be the value of a $10,000 investment in Class A and Class B shares if 

the shares are sold after ( a ) 1 year, ( b ) 4 years, ( c ) 10 years? Which fee structure provides higher net pro-

ceeds at the end of each investment horizon? 

 CONCEPT CHECK 

4.2 

 

Although expenses can have a big impact on net investment performance, it is 

sometimes difficult for the investor in a mutual fund to measure true expenses accurately. 

This is because of the practice of paying for some expenses in    soft  dollars.     A  portfo-

lio manager earns soft-dollar credits with a brokerage firm by directing the fund’s trades 

to that broker. On the basis of those credits, the broker will pay for some of the mutual 

fund’s expenses, such as databases, computer hardware, or stock-quotation systems. The 

soft-dollar arrangement means that the stockbroker effectively returns part of the trading 

commission to the fund. Purchases made with soft dollars are not included in the fund’s 

expenses, so funds with extensive soft-dollar arrangements may report artificially low 

expense ratios to the public. However, the fund may have paid its broker needlessly high 

commissions to obtain its soft-dollar “rebate.” The impact of the higher trading commis-

sion shows up in net investment performance rather than the reported expense ratio.    

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  C H A P T E R  

4

  Mutual Funds and Other Investment Companies 

103

 Investment returns of mutual funds are granted “pass-through status” under the U.S. tax 

code, meaning that taxes are paid only by the investor in the mutual fund, not by the fund 

itself. The income is treated as passed through to the investor as long as the fund meets sev-

eral requirements, most notably that virtually all income is distributed to shareholders. A 

fund’s short-term capital gains, long-term capital gains, and dividends are passed through 

to investors as though the investor earned the income directly. 

 The pass-through of investment income has one important disadvantage for individual 

investors. If you manage your own portfolio, you decide when to realize capital gains and 

losses on any security; therefore, you can time those realizations to efficiently manage 

your tax liabilities. When you invest through a mutual fund, however, the timing of the 

sale of securities from the portfolio is out of your control, which reduces your ability to 

engage in tax management.  

4

  

  

 A fund with a high portfolio turnover rate can be particularly “tax inefficient.”    Turnover    

is the ratio of the trading activity of a portfolio to the assets of the portfolio. It measures the 

fraction of the portfolio that is “replaced” each year. For example, a $100 million portfolio 

with $50 million in sales of some securities and purchases of other securities would have 

a turnover rate of 50%. High turnover means that capital gains or losses are being realized 

constantly, and therefore that the investor cannot time the realizations to manage his or her 

overall tax obligation. 

 Turnover rates in equity funds in the last decade have typically been around 60% when 

weighted by assets under management. By contrast, a low-turnover fund such as an index 

fund may have turnover as low as 2%, which is both tax-efficient and economical with 

respect to trading costs.    

    4.5 

Taxation of Mutual Fund Income  

  

4

 An interesting problem that an investor needs to be aware of derives from the fact that capital gains and divi-

dends on mutual funds are typically paid out to shareholders once or twice a year. This means that an investor 

who has just purchased shares in a mutual fund can receive a capital gain distribution (and be taxed on that dis-

tribution) on transactions that occurred long before he or she purchased shares in the fund. This is particularly a 

concern late in the year when such distributions typically are made. 

 An investor’s portfolio currently is worth $1 million. During the year, the investor sells 1,000 shares of 

FedEx at a price of $80 per share and 4,000 shares of Cisco at a price of $20 per share. The proceeds are 

used to buy 800 shares of IBM at $200 per share.  

    a.   What was the portfolio turnover rate?  

    b.   If the shares in FedEx originally were purchased for $70 each and those in Cisco were purchased for 

$17.50, and the investor’s tax rate on capital gains income is 20%, how much extra will the investor 

owe on this year’s taxes as a result of these transactions?   

 CONCEPT CHECK