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04/29/93

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Mutual fund rankings misleading to investors, economists find

STANFORD -- Widely published rankings of mutual fund performance could mislead many investors because they don't include the effect of income taxes on the funds' performance, two Stanford University economists find in a new analysis of mutual fund performance over the past 30 years.

Investors in the highest tax brackets are especially likely to find that some of the top ranked funds aren't really the best funds for them once taxes are taken into account, say John Shoven, the Charles R. Schwab Professor of Economics, and Joel Dickson, a graduate student in the Economics Department.

"The results are dramatic. The pre- and post-tax rankings differ markedly," they say of the rankings they made of 148 growth and growth- and-income funds.

Mutual funds publish long-term performance statistics that are used as the basis for rankings reported in the financial press, but these statistics ignore investor-level taxes.

Such statistics are appropriate for people who invest in equity mutual funds via tax-deferred group pension plans or individual retirement accounts, they said. They are not for those investing outside the tax sheltered pension system.

"More than half the money in equity mutual funds is outside the tax- sheltered pension fund system, and yet, almost none of the available information regarding mutual fund performance considers shareholder level taxation," Shoven and Dickson wrote in a paper published by the Stanford Center for Economic Policy Research. The work was initiated and supported by Charles Schwab & Co.

"Our basic conclusion is that most mutual fund investors need more information about tax effects in order to make informed decisions," they said.

One reason for the difference in pre- and post-tax performance relates to how quickly fund managers turn over their portfolios.

"Many of our funds churn their portfolios significantly over a single year (100 percent is not uncommon), possibly realizing capital gains as they accrue, and thus, subjecting their shareholders to tax liabilities," the economists said.

The fund in the study with the lowest average turnover - Franklin Growth - "jumped from the 40.5 pre-tax percentile ranking to the 74.3 percentile for a high-tax investor over the 1983-1992 period," they said. Franklin Growth had a 3.2 percent average, annual portfolio-turnover rate during that 10-year period.

High turnover, however, doesn't automatically mean that investors will hand over a large chunk of their profit to the government in taxes. Fidelity Value, with a 296 percent turnover rate, also improved its post- tax performance, jumping 35.8 percentile points in the rankings over the 1983-1992 period.

"Funds with high turnover rates may still be good investments for the tax-conscience investor," Shoven and Dickson said, which is why they recommend listing post-tax results for investors in three tax rate categories.

The researchers calculated the post-tax returns for three individuals, one with the median adjusted gross income for each year between 1963 and 1992, one with adjusted gross three times the median and one with income 10 times the median.

Mutual fund liquidation values may also need to be reported to help investors make prudent short-term investment decisions, the economists said. The liquidation value of a mutual fund share is the amount of money an investor would receive if he or she were to liquidate it at the end of a specific holding period, such as 10 years, a relatively short investment horizon.

"This value best describes the opportunities for those investors divesting assets at the end of the period for a specified purpose," such as for tuition payments, a down payment on a house or buying a yacht, Shoven and Dickson said. They found that "neither pre-tax or post-tax rankings provides an accurate assessment of comparative performance" for investments liquidated in 10 years.

The researchers said they are still working on analyses that would weave a consideration of mutual fund risk into comparative information.

"While we feel that more work is necessary to satisfactorily account for risk [in performance rankings], this consideration does not dampen our main conclusion that after-tax performance rankings are very different from pre-tax performance rankings," they said.

Their report "Ranking Mutual Funds on an After-Tax Basis," includes appendices that list the pre- and post-tax performance over 10- and 30- year periods for high, medium and low tax investors in the funds studied. Copies may be obtained from the Center for Economic Policy Research, 100 Encina Commons, Stanford University, Stanford, Ca. 94305 [telephone (415) 725-1874].

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