The value of unrealized gains in mutual funds is a critical issue in an environment where retail investors are increasingly considering tax efficiency when deciding to invest, or continue to invest, in mutual funds.

Although unrealized gains are generally seen as one of the primary indicators that reflect efficiency in the tax management of a fund, they can also be seen as unattractive to some investors.

On the positive side, unrealized gains in a portfolio mean that the effective tax rate on the gains can be significantly less than the nominal tax rate simply because tax on the gain is deferred. In addition, where the tax system has different rates of tax on gains depending on the period that the asset has been held, deferring tax on realization of the gains can also reduce the effective tax rate on the gains because it achieves a more favorable tax rate.

Large unrealized gains in a mutual fund portfolio are usually associated with low turnover of the assets in the portfolio, thereby making high turnover something to be avoided. That notion, however, is not absolute in that some level of turnover of assets in the portfolio is acceptable (euphemistically called “cholesterol turnover” — some is good and some is bad), which is how gains are realized to offset tax losses within the portfolio. In the same way tax efficiency is achieved when unrealized gains defer the payment of tax, realizing gains to offset against tax losses adds value to the portfolio because it uses the benefit of the tax losses as soon as possible.

On the negative side, however, some investors see large unrealized gains in a portfolio as unattractive. Those investors note that new investors in the fund take on some of the tax liability on the unrealized gains that have been derived by exiting investors, assuming that assets were not sold to fund the exiting investors’ redemptions.

Nevertheless, given investors’ focus on after-tax returns and the significance of unrealized gains in efficiently managing a portfolio on an after-tax basis, the question is, Do the reporting measures for after-tax performance adequately disclose the level of unrealized gains in the fund so that investors can make properly informed decisions?

One would think not.

The methodology for measuring a mutual fund portfolio’s after-tax performance (both required by regulators and recommended by some representative bodies)¹ provides investors with insight into two broad aspects of the tax management of the fund. First, the methodology gives some indication about the tax efficiency of the annual earnings and distributions of the fund (e.g., tax-preferred and fully taxable distributions). Second, it gives investors some indication of the unrealized gains in the fund through the requirement to calculate the after-tax postliquidation values at various intervals.²

The second aspect of the methodology goes some way in informing investors about the fund’s unrealized gains position. It has limitations, however, in fulfilling that function because it assumes that all unrealized gains in the portfolio will be realized at the end of the period, which necessarily overstates the payable tax.

Also, after-tax calculations of assumed liquidations of the investor position provide only a speculative view about the unrealized gains position of the fund.

So, is there a better way to inform both potential and current investors annually about the proportion of unrealized gains in the fund, given the critical nature of that knowledge to investors who are seeking tax-aware performance of the fund?

Several methods (other than those required by law or industry bodies) that resolve a fund’s unrealized gain position into a single number or indicator have been suggested as a way of better informing potential and current investors. First, James Poterba suggested the “accrual equivalent capital gains tax rate,” which is the hypothetical tax rate that could be assessed if the unrealized gains had been incurred at termination instead of over several periods.³ A second method, suggested by Stephen Horan et al., estimates the portfolio’s after-tax future cash flows and value and then applies a tax-adjusted, risk-adjusted discount rate to determine the portfolio’s after-tax value.⁴

Yet, although work continues on finding the best method for measuring and reporting unrealized gains in mutual funds, a threshold issue is just beginning to be researched: the relevance of the tax efficiency of mutual funds and the use by both financial advisers and retail investors of reported data on the tax efficiency of investing.

Horan and Adler showed that more than 90 percent of respondents to their survey used some measure of tax efficiency in their selection criteria for mutual funds, with portfolio turnover the most frequently used, followed by embedded unrealized gains, historical taxable distributions, the tax-cost ratio, and tax-loss carryforwards.⁵ That survey also highlighted investor expectations about mutual funds’ managing tax efficiently (78 percent).

As already noted, turnover can both add and destroy value; so, perhaps it is not the best measure for determining tax efficiency. Nevertheless, given the importance of unrealized gains in the tax efficiency dynamic, it should be the preferred measure of tax efficiency.

Gordon Mackenzie is a researcher and teacher in the Australian School of Taxation, Faculty of Law, at the University of New South Wales, Sydney.