It seems almost guaranteed that 2002 will not be a memorable year for investment performance. However, performance reporting is another matter. This year has seen sweeping changes from the SEC in regard to after-tax reporting of mutual funds. Not to be outdone, the Association for Investment Management Research (AIMR) is redrafting standards for the red-hot separate accounts industry. This is a significant and much-needed development enabling advisors to better serve their taxable clients. As an advisor, it is important to understand what AIMR is requiring of "separates" managers, how this differs from mutual fund reporting, and what this means to you and your taxable clients.
This spring, the SEC began requiring all mutual funds to disclose after-tax returns in prospectuses and annual reports. Funds must now reveal what an investor, starting with cash, would have received in after-tax returns for one-, five-, and ten-year periods. Pretax returns are adjusted using the top federal rate and then displayed in two ways: returns after taxes on distributions (preliquidation); and returns after taxes on distributions and sales of fund shares (postliquidation).
Preliquidation returns apply to investors who did not redeem shares. In this case, investors hold their shares for the measurement period and pay taxes only on capital gains and dividend distributions. Postliquidation returns assume investors sell their shares at the end of the period and pay capital gains taxes. The SEC requires both returns to offer investors the "big tax picture" for both manager trading and shareholder redemptions.
The newly available mutual fund numbers reveal that the returns and relative rankings of various funds can meaningfully shift when taxes are considered. The new numbers give taxable investors a way to assess a manager's impact on their true bottom line. This reporting has already proved helpful in identifying those funds that deliver better after-tax performance. Using Morningstar data and comparing the rankings of the two largest stock funds, the Vanguard 500 Index Fund and Fidelity Magellan, we see a clear example. On a prefee, pretax basis, Vanguard ranks 67th out of 121 diversified U.S. stock funds over the last ten years; Magellan ranks 82nd. Using the new SEC numbers for after-tax, after-fee performance, Vanguard vaults to 39th and Magellan moves to 75th.
So far this information is only required in prospectuses and annual reports. As a result, advisors need to do more due diligence or use other sources to find a firm's after-tax performance.
The Separate Accounts Challenge
AIMR has been providing investment performance guidelines since the late 1980s. "AIMR compliance" has become shorthand for the industry's highest level of performance reporting, directed toward money managers who administer individual or institutional separate, private, and nonpooled accounts.
AIMR plans to release its guidelines for reporting after-tax performance on separate accounts this fall.
The SEC may have beaten AIMR to the punch in requiring after-tax performance disclosure, but not for lack of foresight. AIMR established a subcommittee on after-tax reporting in 1994. What has made AIMR's work challenging is that separate accounts are profoundly different investment vehicles requiring a more complex, flexible approach.
The immense popularity of separately managed accounts stems from their ability to be customized to accommodate investors' tax, risk, and social investing preferences. Over the past five years, separately managed accounts have outpaced mutual funds in growth rates–in large part due to flows from high-net-worth taxable investors. (From 1996-2001, separate accounts grew at a 21% compound annual growth rate to over $400 billion in assets.)
For separate account after-tax reporting, AIMR sees the need for different reporting requirements to better capture the customized moving parts. They allow for customized tax rates, customized investment flows, and the distribution of capital losses. Here are the key differences from the SEC reporting requirements.
1. Custom Tax Rate Recognizing that separate account reporting is for each individual client, AIMR recommends using the client's expected tax rate–including state and local taxes–which it calls the anticipated tax rate. This is a departure from the SEC requirement that only the highest federal rates be used.
According to AIMR, the anticipated rate should be the tax rate that the manager expects the taxable client to face on returns for that period. This requires interaction between the manager and advisor/client in determining the anticipated rate through the development of investment policy guidelines. The tax rate should be determined at the beginning of the reporting period and should guide the manager in decision-making. This could result in a customized report for the client based on residence in a high-tax state or an AMT status. If the anticipated rates are unknown, which is often the case with wrap accounts, it is permissible to use the maximum federal tax rates.
