STRATEGY SHEET
August 2001
The Benefits of Tax-
Efficient Equity Funds
© Talbot Stevens
Despite the fact that tax rates have finally started to come down in most areas of the country, the tax-efficiency of your equity fund can make a big difference, especially when investing outside of RRSPs.
There are effectively two strategies that fund companies use in an effort to keep taxable distributions as low as possible and increase tax-efficiency.
A few fund managers model the Warren Buffet philosophy of trying to buy great companies at a great price and holding a long time. This minimizes both transaction costs, and more importantly, the capital gains taxes that are triggered each time an investment is sold for a profit.
The reality with most mutual funds is that investment gains that cannot be offset by losses are distributed to investors each year. These distributions are taxable in the investor's hands, leaving less money to grow tax-deferred in the form of a capital gain.
Deferral of tax, or any expense, is always beneficial if the cost tomorrow is not substantially higher than the cost today.
I read an article once where Warren Buffet, who many regard as one of the best investors of all time, claimed that his approach of holding great companies "forever" increased his annual returns by 2-3% per year. While this relatively small increase might not seem like much, compounded over 30 years, a 3% increase in returns can double a retirement fund.
The newer approach to producing tax-efficient equity funds is the use of a corporate share structure. The majority of fund companies are structured as trusts, which produce a taxable gain or loss when an investor switches from one fund to another.
A few fund companies have set up a group of equity funds using a corporate structure. These equity funds typically invest in different sectors or geographical areas, and are designed to allow investors to switch between funds in the group without triggering capital gains. The additional benefit of these special corporate shares is their mandate to have low or no distributions, although this is not guaranteed.
Although these corporate structures do not allow you to switch between different asset classes tax-free as you can inside an RRSP, they do allow you to defer taxes when you make changes to the equity portion of your portfolio. Capital gains taxes are triggered when you redeem shares from the corporation.
Unregistered equity investing became more tax effective in 2000, as the capital gains inclusion rate dropped from 75% to 50%. This change can increase the after-tax value of a 30-year investment by 20%.
To learn more about which fund managers adopt the hold long-term approach with low distributions and which fund companies offer a family of corporate shares for tax-deferred switching, contact your financial advisor.