July 10, 2000
Mr. Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 5th Street, N.W.
Washington, D.C. 20549-0609
Re: Disclosure of Mutual Fund After-Tax Returns (File No. S7-09-00)
Dear Mr. Katz:
The Vanguard Group1 is pleased to have the opportunity to comment on the Securities and Exchange Commission's proposed rule on disclosure of mutual fund after-tax returns. Given Vanguard's long-standing efforts to inform investors about how fund managers' discretionary actions affect returns, we enthusiastically support the spirit of the proposal to require after-tax return disclosure. Vanguard is a recognized leader within the mutual fund industry in educating shareholders on the importance of after-tax returns. Beginning with fiscal year 1998, we began reporting after-tax returns in the annual reports for our tax-managed funds. We extended our after-tax return reporting to all equity and balanced funds in fiscal year 1999 so that our existing shareholders could assess the tax cost of their investments. Our experience demonstrates that after-tax returns can be presented in a way that investors understand and that is not burdensome to the fund sponsor.
The issue of after-tax return disclosure is an important one. For the taxable investor, a fund's pre-tax return is not the return that is actually received by the shareholder. Even with the rise of tax-deferred vehicles (e.g., IRAs and 401(k) plans) over the past two decades, the majority of equity mutual fund assets are still held in traditional, retail accounts.2 For these investors, standardized SEC performance, which is pre-tax performance, does not represent the most appropriate performance measure because it assumes that no tax is due on a fund's dividend and capital gain distributions. Yet it is these performance numbers that are used in mutual fund prospectuses and advertising materials aimed predominantly at the retail mutual fund investor.
Our specific comments are presented in two parts. The first section of our response highlights the four key areas that Vanguard would stress to meet the objective of providing relevant, clear, and concise information to shareholders regarding how their fund manager affects the return of the portfolio for taxable investors. The second section presents responses to some of the other specific questions for which the Commission sought comment.
I. Presenting After-Tax Returns to Shareholders
The Commission's proposed rule on after-tax return disclosure raises a number of important issues-both philosophical and mechanical-that must be addressed in order to present this information to shareholders. Viewing the proposal from the shareholder's perspective, however, requires one to "step back" and assess the overall objective. In our opinion, shareholders do not currently receive relevant information on how a fund manager's actions affect the after-tax performance of their investment. Therefore, shareholders would benefit most from a presentation of after-tax returns that allows for simple, easily understood and replicable returns that concisely communicate how a fund has performed. Given this goal, Vanguard would stress four key themes in any requirement to disclose after-tax returns:
A. A Fundamental Question
Is the disclosure of after-tax returns a performance issue or a tax issue? The Commission's answer to this question will determine the scope and direction of any requirements for funds to provide after-tax returns. Vanguard firmly believes that after-tax return disclosure is essential to an understanding of mutual fund performance. Fund sponsors and fund managers, through discretionary actions, have the ability to affect a fund's return. Setting fees, adopting accounting practices, and making decisions on which securities to buy or sell within the portfolio all can affect a fund's pre-tax and after-tax total return. More importantly, these decisions affect funds differently, leading to variations in returns that shareholders should assess in evaluating fund or manager performance.
Over the last decade, high-tax-bracket investors in the average diversified, domestic equity mutual fund lost 2.5 percentage points annually to taxes on fund distributions.3 However, the dispersion of these tax bites was great, ranging from zero (i.e., the pre-tax and after-tax returns were the same) to 7.6 percentage points per year. In addition, academic studies on after-tax mutual fund performance4 have demonstrated that:
Others in the industry appear to view the disclosure of after-tax returns solely as a tax issue. They generally would propose burying these returns in a tax section-if they are disclosed at all-separate from other (pre-tax) returns. In addition, those that support this view might suggest "simplifying" assumptions to make any calculations easier even though they may have no basis in current tax law.
Vanguard strongly disagrees with the position that after-tax return disclosure is simply a tax issue. Taxable shareholders receiving pre-tax return information should be able to assess the amount of their return lost to taxes. Taxes have as real an impact on performance for taxable shareholders as the fees presently reflected in return calculations. This proposal is more than merely providing after-tax "numbers." Simply put, after-tax returns are the most appropriate performance figure for shareholders holding a fund in a taxable account.
B. Location of Disclosure
Given Vanguard's view that after-tax return disclosure is fundamentally a performance issue, we believe that after-tax returns should be presented wherever pre-tax returns are presented. Currently, performance disclosure is required in the risk/return section of the fund's prospectus and Management's Discussion of Fund Performance (MDFP), which is usually contained in the annual report. Disclosure of standardized performance is currently optional in advertisements and supplemental sales literature. In particular, we feel that after-tax returns are a natural discussion topic for the MDFP because a manager's actions directly impact after-tax fund performance. Generally, because we see this as a performance issue, we recommend that after-tax returns be required in the risk/return section of the prospectus, the MDFP, and any advertisements or supplemental sales literature that presents pre-tax (i.e., standardized) performance.5
Requiring after-tax returns in performance-related advertisements is arguably even more important than presenting the information in prospectuses and annual reports. Both anecdotal evidence and rigorous academic study show investors' propensity to chase past performance even though past (pre-tax) performance is generally not predictive of future performance.6 That said, many prospective investors believe that past performance is an indicator of manager skill. The industry recognizes this fact and, frankly, many firms use performance advertising to lure investors into considering "hot" funds over other funds that might be more appropriate for their investment goals.7 In addition, performance ads are disproportionately targeted to the retail, taxable investor where there is more discretion to choose among myriad mutual fund options.8 The Commissioners and SEC staff members have frequently urged the mutual fund industry to act responsibly in promoting mutual fund performance.9 It is evident that responsible performance advertising should include the most relevant performance numbers-namely, after-tax returns.
While others may argue that including after-tax returns in advertisements would be especially burdensome from a disclosure perspective, we do not believe this argument has merit. Such disclosure would be no greater than other standardized statistics that are used in advertisements. In these cases (e.g., standardized performance, SEC yield, tax-equivalent yield), much of the detail about the many assumptions used in the calculation is relegated to the Statement of Additional Information (SAI) with little disclosure contained explicitly in the advertisement. The only disclosure that we feel would be necessary in advertisements would be the same footnote we propose for the risk/return section of the prospectus (discussed below).
C. Calculation Methodology
The Commission proposes to require two sets of after-tax returns: a pre-liquidation return and a post-liquidation calculation. The pre-liquidation return, referred to as the after-tax return "if you continue to hold your shares at end of period" in the Commission's proposed rule, identifies how the adviser's actions affected all shareholders in the fund. This calculation taxes distributions of dividends and capital gains that are distributed to every shareholder based on their pro-rata ownership of fund shares. The post-liquidation figure, referred to in the proposed rule as the after-tax return "if you sell your shares at end of period," takes the pre-liquidation return and then assumes a shareholder redemption, which may or may not actually occur, at the end of the period. Any additional tax liability resulting from the redemption is incorporated into the calculation. In addition, any back-end loads or other non-recurring redemption fees would be incorporated into the post-liquidation calculation.
We believe that the pre-liquidation return is the appropriate after-tax return for taxable fund shareholders. By taxing the fund's resulting distributions, this figure incorporates all of the discretionary fund management techniques that could result in higher or lower after-tax returns, including, but not limited to, the effects of turnover, accounting practices, tax-management policies, portfolio dividend yields, expense ratios, and capital gain realization patterns. As such, the pre-liquidation return explicitly meets the goals of after-tax return disclosure; namely, to provide a straightforward method to assess how fund management practices have affected the fund's after-tax return and to compare these effects across funds. On the other hand, post-liquidation numbers do not further the goal of helping shareholders assess the after-tax performance of the fund adviser and introduce complexities that undermine the clarity of the disclosure.
The pre-liquidation return is somewhat intuitive in that it will never be higher than the fund's investment return (i.e., the pre-tax return without respect to loads or other non-recurring fees). From a computational standpoint, the post-liquidation number might be higher or lower than either the pre-tax return or the pre-liquidation after-tax return, which requires significant explanation for shareholders. Consider the following returns for a Vanguard fund:
|Average Annual Total Returns as of May 31, 200010|
|1 Year||5 Years||10 Years|
Vanguard Windsor Fund's one-year post-liquidation figure is higher than its pre-liquidation return because the deemed redemption in the post-liquidation context would have resulted in a capital loss from which the shareholder would receive a tax benefit. However, the five and ten-year post-liquidation numbers are less than their pre-liquidation counterparts. This apparent discrepancy would require significant explanation in disclosure documents but would not enhance a shareholder's understanding of how the fund is managed on an after-tax basis. The added explanation is needed only because of a hypothetical shareholder-specific redemption that did not affect the management of the fund. While it is important that shareholders understand that there may be tax effects resulting from a decision to redeem and how to get information about these tax effects specific to their circumstances, the hypothetical presentation of post-liquidation returns are too attenuated to be particularly helpful.
Of course, to the extent shareholders have benefited from tax deferral through lower taxable distributions over their investment horizon, a relatively larger tax burden may occur upon redemption. That is, the pre-liquidation calculation can overstate the after-tax return to shareholders who may ultimately redeem their shares. However, we feel this is best handled through narrative disclosure (e.g., "Your decision to sell shares may result in additional tax liability."). Quantifying the effect of the redemption within an after-tax return is extremely difficult because it depends on the specific tax situation of the redeeming shareholder. The after-tax return upon redemption would depend on the actual cost basis of the investor's positions, whether the investor has other realized capital losses to offset any capital gain, whether any realized losses could be used to offset ordinary income, and whether the investment is being liquidated through an estate or charitable giving (in which case no capital gain would be taxed). Vanguard believes that post-liquidation information is best provided to shareholders by means of web calculators that perform this function and provide investors with far more accurate post-liquidation return information.11
For the sake of simplicity, clarity, and comparability, Vanguard proposes that only one after-tax return-a pre-liquidation figure-should be required.12 In addition, our proposed format for return disclosure (presented below) would allow investors to see clearly how a fund's return is composed of investment return, fees, and taxes.
D. Format of Disclosure
Instead of the four-figure approach in the proposed rule, Vanguard suggests the following format for presenting after-tax returns:
|Average Annual Total Returns
(For the periods ended _______)
|1 Year||5 Years||10 Years|
We believe this approach simplifies the Commission's proposed return disclosure, and clarifies explanations of performance for prospective and current shareholders. In particular, this approach:
As previously noted, we think that most of the calculation methodology and assumptions can be presented in the SAI, as is the case with most other standardized calculations (e.g., SEC yield, tax-equivalent yield, SEC performance). However, we do feel that the after-tax return figure should be footnoted with the following text:
After-tax performance is calculated using the highest individual federal tax rate and assumes the investment is not sold at the end of the period. Your decision to sell shares may result in additional tax liability.
E. After-Tax Returns for Bond Funds
One of the Commission's stated purposes for requiring after-tax returns is to allow investors to compare after-tax returns across funds. Vanguard concurs with many others in the industry that after-tax returns should not be required for bond funds (both taxable and tax-exempt) because shareholders choosing among fixed-income investment options already have the ability to take their own tax situation into account by choosing between taxable and tax-exempt bond funds.18 In fact, the industry recognizes that this choice is largely dependent upon the tax bracket of the investor, and the SEC has developed a standard tax-equivalent yield calculation that funds may report to assist shareholders in their evaluation of fixed-income funds. After-tax return disclosure for bond funds based on a single tax rate could run counter to the tax-equivalent yield calculations by misleading investors who may not be in the tax rate used in the calculations.
The table below demonstrates the different conclusions that may result from using a specific tax rate assumption in the calculation methodology. The after-tax returns for an existing taxable bond fund and an analogous tax-exempt bond fund are compared, using tax rates that correspond to today's federal rates of 39.6% and 28%.19 In both cases presented, the 28% tax bracket investor would have had a higher return with the taxable bond fund. However, if this investor were evaluating these alternatives using the calculation methodology in the Commission's proposed rule, the tax-exempt bond fund would appear to have been the better option.
|After-Tax Returns for Selected Vanguard Funds
(10 Years ending May 31, 2000)
|28% Bracket||39.6% Bracket|
|Vanguard Long-Term Treasury Fund
Vanguard Insured Long-Term Tax-Exempt Fund
|Vanguard Short-Term Federal Fund
Vanguard Short-Term Tax-Exempt Fund
II. Comments on Selected Provisions in the Commission's proposed rule
A. Requirement to Disclose After-Tax Return
"Is this information useful to, and understandable by, investors?"
Yes. Vanguard began publishing after-tax returns with accompanying disclosure-with all of the disclosure items required in the Commission's proposed rule for pre-liquidation returns-beginning with the fiscal-year 1998 annual reports for our Tax-Managed Funds. This disclosure was extended to all our balanced and equity funds (with the exception of our REIT Index fund) for fiscal year 1999. Our shareholders have responded favorably to our voluntary disclosure. This information has raised their awareness of how taxes affect their returns, and we have seen greater concern about funds' tax efficiency as a result of our disclosure. To the extent shareholders are thinking about taxes in the context of their overall investment program, we view our efforts to present after-tax returns as very successful. Moreover, we have had very few inquiries requesting clarification of the pre-liquidation returns included in our annual reports, so we believe our shareholders understand the information as presented. We should note, however, that there has been some confusion about the differences between pre-liquidation and post-liquidation returns for shareholders using our web-based calculator. Specifically, shareholders do not seem to understand how the after-tax, post-liquidation figure could be higher than the fund's pre-tax return.
"Should disclosure be mandatory only for funds that hold themselves out as "tax-managed" or otherwise managed with a view toward shareholder tax consequences?"
No. Vanguard believes that disclosure should be mandatory for all funds (except those specifically excluded by the proposed rule and bond funds as discussed previously). Our view is that mutual fund managers have meaningful control over the tax burdens they place upon their shareholders, which directly affect investors' returns. Because we view after-tax returns as a performance issue, and not simply a tax issue, disclosure of after-tax returns should be required in conjunction with other required return calculations so that investors can better evaluate the impact of taxes on mutual fund returns. The goal of any shareholder's investment program should be to maximize after-tax return. If a shareholder believes that a particular manager will generate a high enough return relative to other investments (including "tax-managed" funds) to offset any negative tax impact to fund performance, then that investment may be an appropriate choice. Without after-tax return information, however, shareholders may find it difficult to compare after-tax returns across broad groups of funds.
Vanguard also believes that certain other investment vehicles subject to registration under the Investment Company Act of 1940 that are not currently included in the proposed rule should also be subject to the disclosure requirements. The proposed rule seems to indicate that only open-end mutual funds would be required to publish after-tax returns. Unit investment trusts, including certain exchange-traded funds, and closed-end funds have similar investment structures to open-end mutual funds and appeal to a similar investor base. Therefore, we see no reason to exclude them from the regulations.
B. Location of Required Disclosure
"Should this information be included in the prospectus, annual report, profile, or elsewhere?"
As stated earlier in our letter, Vanguard believes that after-tax returns should be required whenever return data are presented. This would include the prospectus, profile, annual report, and advertisements and supplemental sales literature that include performance information. Regardless of where the Commission ultimately decides to require after-tax return information, we feel strongly that after-tax returns should not be separated from their pre-tax return counterparts. Separating pre-tax and after-tax returns would obscure the stated goals of the rule to allow investors to assess how the management of their fund affects their after-tax return.
"Does the proposed table present before-tax and after-tax return information in a clear and understandable way? Do the proposed captions adequately describe the information presented? Will investors be able to understand the presentation for funds with multiple share classes and multiple portfolios? Is there a more effective way to present after-tax returns for these funds?"
As proposed, Vanguard thinks that two returns labeled "Before-Tax Return" and two returns labeled "After-Tax Return" will be confusing to investors and especially burdensome for multiple share classes because the set of four returns would need to be shown for each share class. We believe our alternative-where funds would show two pre-tax returns and one after-tax return-is more straightforward. In addition, our proposed presentation offers a further benefit of clarifying the sources of fund performance by separately identifying the breakdown of a fund's return to fees, taxes, and investment performance.
Only one return series-the currently required standardized performance that includes sales loads and non-recurring purchase and redemption fees-would need to be shown for each share class, allowing investors to distinguish fee differences among share classes. This requirement comports with current regulation. The additional returns we propose-a pre-tax return ("Investment Return") computed without respect to loads or other non-recurring fees and an after-tax return based on the "Investment Return" but that taxes fund distributions-would show the difference in tax burden due to the fund's management practices. With the exception of expense ratio differences, which affect the level of dividend distributions, the tax burden of other share classes will be similar.20 Hence, investors can obtain information about how taxes have affected the fund's performance by illustrating just one share class.
Vanguard's experience in reporting after-tax returns in our annual reports suggests that it can be done clearly and effectively. Our current disclosure takes up less than one page while meeting all of the requirements of the proposed rule for pre-liquidation returns. If final regulations containing a standardized after-tax return formula are issued, much of the explanation would be unnecessary because the details of the performance calculation and assumptions could be presented in the Statement of Additional Information (SAI), as is currently done with other standardized calculations that funds may report.
C. Formulas for Computing After-Tax Return
1. Tax Bracket
Vanguard supports the Commission's proposal to use the highest federal marginal tax rate in the calculation for after-tax returns because it does represent the "worst-case" scenario under federal guidelines and it is easy to track through time. However, we do have some suggestions for simplifying the tax bracket discussion. We propose that the final rule include references to the Internal Revenue Code (IRC) section (Section 1) where the federal marginal tax rates are published. Under this approach, no annual updates or clarification from the Commission would be needed if the highest marginal tax rate changes in the future because the rule would be updated automatically with changes to the IRC. Secondly, we would also suggest incorporating clarifying language into the final rule that marginal tax rates on other forms of taxable income (e.g., long-term capital gains) correspond to the rates that would be applicable for a taxpayer subject to the highest marginal income tax rate. This could also be accomplished by reference to Section 1 of the IRC.
Although we support the use of the highest federal marginal tax rate in after-tax return calculations, Vanguard is not opposed to using an alternative rate. We are sensitive to the argument that using the highest tax bracket would not reflect the experience of the "average" investor. However, the use of another rate could be more complicated to communicate and monitor over time. If another tax rate is used, we feel it is important that the methodology automatically adjusts for inflation and does not place any undue burden on the Commission to revisit the issue periodically.
2. Historical versus Current Tax Rates
We support the use of historical tax rates and would strongly oppose the use of current tax rates in historical after-tax return calculations. Mutual fund managers may react to changes in the tax code, and shareholders could not assess these decisions if current tax rates are used. For example, it was known in the latter part of 1986 that the highest individual federal marginal tax rate on long-term capital gains was going to increase from 20% to 28% as of January 1, 1987, as a result of passage of the Tax Reform Act of 1986. A mutual fund manager could use this information to sell his/her position in a stock (and distribute those proceeds to shareholders) before January 1, 1987, thereby providing a potential tax savings to the fund's shareholders. If this fund were computing its after-tax returns in 1987 and forced to use current tax rates, this benefit would not be apparent because all prior distributions of long-term gain would be taxed at 28%. The use of current tax rates would negate the ability of existing and prospective shareholders to assess how tax considerations have been incorporated in the management of the fund.
3. Calendar versus Fiscal Year Measurement Period
Given Vanguard's support for requiring disclosure in both the prospectus and MDFP, we feel that separate calendar and fiscal year calculations should be made in order to correspond with the pre-tax returns presented in these locations. Because funds have some discretion over when to make dividend and capital gain distributions, some timing issues could result from the new rule. In particular, if equity markets generally rise over time, then funds would want to distribute taxable income to shareholders as late in the reporting period as possible in order to minimize the opportunity cost associated with deducting taxes due at the time of the distribution. Also, funds might want to defer distributions of taxable income into future reporting periods, whenever possible.
Although funds could theoretically change their distribution policies to try to improve after-tax returns within the context of the proposed rule, we think that such attempts to manipulate the calculation would be unlikely because the benefits of making such changes would not outweigh the costs and communications burdens. In addition, certain features of existing tax law and the SEC's proposed rule mitigate the risks associated with funds trying to time their distributions in a potentially misleading way. For example, funds generally must declare capital gain distributions based on an October 31st fiscal-year end by the end of each calendar year or be subject to a nondeductible 4% excise tax.21 This has the effect of not deferring significant capital gain distributions past the end of the calendar year.22 In addition, the proposed rule would require fiscal and calendar year calculations, thereby reducing the ability to time distributions to the extent a fund's fiscal year differs from the calendar year. In these cases, trying to time distributions on a calendar year basis could potentially accelerate taxes in a fiscal year calculation.
One potential area of abuse would be the calculation of after-tax returns for periods of less than one year (e.g., year-to-date returns or since inception returns for a new fund). Without some anti-abuse provisions, funds could report year-to-date after-tax returns just before a large distribution, suggesting to shareholders that their approach had been tax efficient when, in fact, a taxable distribution is just about to be made. This problem would be most likely associated with advertising, where funds must present returns as of the most recent calendar quarter.23 To remedy this possibility, Vanguard recommends that non-standardized after-tax returns not be permitted for periods of less than one year.
4. State and Local Tax Liability
We concur that state and local taxes should not be considered in the calculation of after-tax returns. Any attempt to incorporate state and local taxes would be complicated and could potentially require significantly more disclosure, without much additional information being presented to shareholders unless it were done for each state and municipal taxing authority. Obviously, incorporating all of the different state and local tax rates would be a significant reporting burden and require continuous monitoring to adapt to any state and/or local tax changes. Also, we would argue that simply incorporating a state and local marginal tax rate (even if it were a single "average" rate) would not be sufficient to incorporate state and local taxes because of the significant differences in federal versus state and local tax treatment of mutual funds.
5. Federal Alternative Minimum Tax and Phaseout Adjustments
We concur that after-tax return formulas should not reflect the impact of the alternative minimum tax (AMT), current phaseouts, or other taxes or adjustments not reflected in the proposed formulas. That said, the proposed rule is written from the perspective of today's tax laws and does not adequately address how the proposed calculations would change with future tax law changes affecting mutual funds and their shareholders. This omission could place an unwanted burden on the Commission to revise its proposed rule any time there is a change to the tax law in order to interpret its applicability to the after-tax return formulas.
Vanguard would suggest a modification to the description of the calculation methodology in order to allow for future, unforeseen changes to the tax law affecting mutual fund shareholders. Mutual fund distributions are reported to shareholders on IRS Form 1099-DIV (Dividends and Distributions). This form is updated annually and reflects tax law changes affecting the character of mutual fund distributions. We would propose tying the calculation methodology to those items required to be reported to shareholders on the 1099-DIV form.24
The current 2000 IRS Form 1099-DIV requires the following types of mutual fund distributions to be reported: ordinary dividends (the sum of dividend and short-term capital gain distributions), total capital gain distributions (i.e., long-term capital gain distributions), and nontaxable distributions. In addition, some components of the total capital gain distributions are also separately reported: 28% rate gain, unrecaptured section 1250 gain, and section 1202 gain. Using the 1099-DIV, funds would be required to incorporate the tax treatment of these distributions-dividends, short-term capital gain, 28% rate gain, unrecaptured section 1250 gain, section 1202 gain, and other long-term capital gain (total capital gain distributions less the separately reported components reported on Form 1099-DIV)-in the computation of the fund's after-tax return. Using Form 1099-DIV as a basis for setting up the components to be used in the after-tax return calculation is consistent with the proposed rule's exclusion of AMT, current phaseouts, or other adjustments because this form does not include any of these adjustments.
6. Timing and Method of Payment
We concur with the treatment suggested in the proposed rule that taxes are paid at the time of the distribution. However, this treatment can lead to timing differences across funds. For example, a fund that pays distributions earlier in the measurement period is penalized if asset prices subsequently rise relative to a fund that pays the same percentage distribution later in the same measurement period because of the lost opportunity cost of the taxes paid. However, having taxes paid at the time of the distribution greatly simplifies the calculation and is more realistic in terms of linking taxable events and their associated tax burden.
7. Tax Treatment of Distributions
We think the explanation of what is included and excluded from the calculation should refer to those items reported on shareholder tax forms, as described above. IRS Form 1099-DIV does include an adjustment for foreign taxes paid by a fund to the extent the fund has elected to pass through these amounts to shareholders.25 As such, our position is that after-tax returns should incorporate appropriate foreign tax credit adjustments. Our reading of the proposed rule suggests that foreign taxes paid by a fund and a shareholder's ability to claim a foreign tax credit would be included in the calculation, though the methodology does not explicitly state how it would be incorporated. We would suggest that a standardized calculation methodology be employed for the inclusion of a foreign tax credit adjustment.26
A foreign tax credit calculation can be introduced into the formulas by modifying the instructions for the After-Tax Average Total Return (Without Redemption) quotation. In particular, the following language should be added to instruction (3):
You may include an adjustment for foreign taxes paid by "grossing up" the amount of ordinary income (not including short-term gains) by the amount of the foreign taxes paid over the measurement period. The tax liability is calculated by multiplying the appropriate tax rate by the grossed up amount and subtracting the value of foreign taxes paid. This liability is then subtracted from the original distribution amount (not grossed up) in computing the after-tax reinvested distribution amount.27 When there are multiple distributions within a reporting period, allocate the foreign tax paid ratably with respect to the fund's dividend distributions.
For purposes of the fiscal year calculation that would appear in the annual report, a fund would need to calculate the foreign tax paid over the course of the fiscal year. The fiscal year foreign tax paid amount will likely differ from the calendar year figure, leading to different gross-up amounts (and, hence, different tax liabilities) for the same distribution, depending on the measurement period.
8. Capital Gains and Losses Upon a Sale of Fund Shares
As we have stated, Vanguard opposes a requirement to publish post-liquidation after-tax returns. However, we do believe a standardized formula is necessary for those who choose to publish post-liquidation after-tax returns. Because this is meant to be a return calculation, we believe it is important to track actual holding periods of each investment (i.e., initial investments and each reinvested distribution) and to apply the appropriate tax treatment (e.g., long-term or short-term) at the time of the deemed redemption.
Our reading of the calculation methodology published in the proposed rule is that the gain or loss upon redemption would be computed on a lot by lot basis. This type of treatment does not correspond to the taxation of a true redemption of fund shares where capital gains and losses must be netted in order to determine their ultimate "treatment" (i.e., short-term loss, long-term gain, etc.). If our reading of the post-liquidation calculation in the proposed rule is incorrect, we feel that some clarification is needed to confirm that the capital gain tax liability is computed with respect to current tax law. If our interpretation of the proposed rule is correct, then we feel that the calculation methodology should be reworded to be consistent with the current tax treatment of multiple sales of fund shares. Specifically, the calculation of gain/loss upon redemption should be computed as follows28:
|Net Long-Term Gain or Loss|
|Net Short-Term Gain or Loss|
|Greater than 0||Less than or equal to 0|
|Greater than 0||
Tax net long-term gain at long-term rate; Tax net short-term gain at short-term (ordinary income) rate.
|Add net short-term gain and net long-term loss. If result is greater than zero, tax amount at short-term (ordinary income) rate. If amount is less than zero, compute deduction from tax using the long-term rate.|
|Less than or equal to 0||Add net short-term loss and net long-term gain. If result is greater than zero, tax amount at long-term rate. If amount is less than zero, compute deduction from tax using the short-term (ordinary income) rate.||Compute deduction from tax on net long-term loss using long-term rate; Compute deduction from tax on net short-term loss using short-term (ordinary income) rate.|
D. Narrative Disclosure
"Comment is requested on the proposed narrative disclosure"
Vanguard does not see a need for expansive narrative disclosure if there is a standardized calculation methodology. As we have already discussed, major disclosure is not required for other standardized formulas (e.g., SEC yield, standardized SEC (pre-tax) performance, tax-equivalent yield), and the calculation methodology is available to investors in the SAI. We think appropriate disclosure could apply to both pre-tax and after-tax returns as follows:
Past performance is not an indicator of future results. After-tax returns are calculated using the highest individual federal tax rate and assume the investment is not sold at the end of the period. Your decision to sell shares may result in additional tax liability.
To the extent that the Commission feels that further narrative disclosure is required, we do think it could be placed separately from the return calculations (e.g., in the tax section of the prospectus or in the SAI).
E. Alternatives to Disclosure of After-Tax Return
"Should the prospectus be required to describe the potential tax consequences to an investor of...purchasing shares in a fund that has significant amounts of unrealized gain in its portfolio securities?"
No. A portfolio's unrealized capital gain position is simply a snapshot of the portfolio's holdings at a point in time and is currently required to be disclosed in the financial statements contained in a fund's annual and semi-annual reports. All this number indicates is the amount of the capital gain that would be realized if the portfolio were to be completely liquidated at that particular point in time. To the extent that only a portion of the portfolio is liquidated or that financial markets fluctuate over time, the amount of capital gain actually realized may have little relationship to the published unrealized capital gain figure.
Furthermore, unrealized capital gain is just one of many variables that could influence a fund's tax efficiency. Granted, academic studies have demonstrated that higher net unrealized gain is an indicator of higher future tax realizations.29 However, it is also recognized that this figure is just one predictor of after-tax returns. There are other predictors (e.g., strong past tax efficiency and low turnover rates) of lower future tax realizations.30 Given these results, how would one describe the after-tax performance factors of a fund that has relatively high unrealized gains, low turnover, and strong past tax efficiency? Highlighting the effect of any single variable as a potential "risk" factor is extremely misleading because tax efficiency is a result of different market conditions as well as portfolio management decisions and characteristics.
The Vanguard Group appreciates the opportunity to present its views on the Commission's proposals, and we look forward to the final rules on after-tax return disclosure. We would reiterate that we believe after-tax return disclosure provides useful, relevant information to shareholders about how discretionary actions by fund managers affect investors' returns. Although we have suggested changes to the Commission's proposed rule that we think will improve the presentation and relevance of after-tax return disclosure to shareholders, we commend the Commission for raising awareness on this issue. We are confident that the final regulations will benefit investors trying to assess fund performance. If you would like additional information, please contact the undersigned at (610) 669-5846 or Heidi Stam, Principal, Securities Regulation, at (610) 503-4016.
Joel M. Dickson
cc: Paul F. Roye, Director, Division of Investment Management
Susan Nash, Senior Assistant Director, Division of Investment Management
|1||The Vanguard Group, headquartered in Valley Forge, Pennsylvania, is the nation's second largest mutual fund firm. Vanguard serves 14 million shareholder accounts and manages more than $560 billion in U.S. mutual fund assets. Vanguard offers 109 funds to U.S. investors and 33 additional funds in foreign markets.|
|2|| Source: Investment Company Institute calculations. Figures exclude variable annuity sub-account assets.
|3||Data derived from Morningstar® Principia® Pro database for 574 funds in existence for at least ten years as of May 31, 2000. After-tax returns are computed using a methodology similar to that proposed by the Commission; specifically, the returns assume distributions are taxed at the highest individual federal marginal tax rate in effect at the time of the distribution.|
|4||See, for example, Joel M. Dickson and John B. Shoven, "Taxation and Mutual Funds: An Investor Perspective," in James M. Poterba (ed.) Tax Policy and the Economy, vol. 9 (1995), Cambridge: MIT Press, pp. 151-181. Also, Daniel Bergstresser and James Poterba, "Do After-Tax Returns Affect Mutual Fund Inflows?," National Bureau of Economic Research working paper #7595, March 2000 (available at http://papers.nber.org/papers/W7595).|
|5||We would exclude any advertisements or sales literature targeted solely to tax-deferred shareholders or for tax-deferred investment vehicles.|
|6||On the relationship between money flows, past performance, and future performance see Erik Sirri and Peter Tufano, "Costly Search and Mutual Fund Flows" Journal of Finance 53 (1998), pp. 1589-1662, and Prem C. Jain and Joanna Shuang Wu, "Truth in Mutual Fund Advertising: Evidence on Future Performance and Fund Flows," Journal of Finance 55 (2000), pp. 937-958. For a comprehensive study on the persistence of past (pre-tax) performance, see Mark M. Carhart, "On Persistence in Mutual Fund Performance," Journal of Finance 52 (1997), pp. 57-82.|
|7||See, e.g., "Look Beyond Returns, Says SEC's Levitt," The Wall Street Journal, May 22, 2000, page C35; "Fund Ads' Disclosures Fuel Controversy," The Wall Street Journal, Jan. 13, 2000, page C1; NASD Notice to Members 00-21, NASD Regulation Reminds Members of Their Responsibilities When Advertising Recent Mutual Fund Performance, (available at http://www.nasdr.com/pdf-text/0021ntm.txt).|
|8||Performance ads targeted to tax-deferred, employer-sponsored plan participants (e.g., 401(k) plans) are of little value because the employer chooses the available investment options. Hence, the proportion of taxable assets in the investor groups targeted by performance ads is significantly higher than the overall industry percentage.|
|9||See, e.g., "The SEC Perspective on Investing Social Security in the Stock Market," Remarks by Arthur Levitt, Chairman, SEC, at the John F. Kennedy School of Government Forum, Harvard University (Oct. 19, 1998)(available at http://www.sec.gov/news/speech/speecharchive/1998/spch223.htm); Remarks by Paul F. Roye, Director, Division of Investment Management, before the ICI's Securities Law Procedures Conference, Washington D.C., (Dec. 7, 1998)(available at http://www.sec.gov/news/speech/speecharchive/1998/spch238.htm); "Challenges for the Mutual Fund Industry in the Competitive Frontier," Remarks by Paul F. Roye, Director, Division of Investment Management, SEC, at the 2000 Mutual Funds and Investment Management Conference, Palm Desert, California (Mar. 27, 2000)(available at http://www.sec.gov/news/speech/spch358.htm); "Our Shared Responsibilities for Fund Compliance," Remarks by Lori Richards, Director, Office of Compliance, Inspections, Examinations, SEC, before the ICI 1999 Mutual Fund Compliance Conference, (June 10, 1999)(available at http://www.sec.gov/news/speech/speecharchive/1999/spch282.htm).|
|10||These returns were calculated using the After-Tax Returns Calculator available at The Vanguard Group's website (www.vanguard.com) and are computed in the same manner as in the Commission's proposal.|
|11||Vanguard provides shareholders the ability to calculate after-tax, post-liquidation returns using a web-based calculator, as do a number of other firms and third-party service providers. Because this tool is meant to allow shareholders to customize their after-tax returns to their tax situation, we believe that including a post-liquidation calculation is appropriate in this format. However, in our annual report disclosure, we only present pre-liquidation returns because we view the annual report as a discussion of how the manager affected the performance of the fund.|
|12||Reporting a pre-liquidation return as the only after-tax return required is also consistent with current performance presentation standards adopted by the Association for Investment Management and Research (AIMR) in creating after-tax composite returns. These standards are available at http://www.aimr.com/standards/pps/ppsstand.html.|
|13||"Fee-Adjusted Performance" represents the currently required standardized SEC performance calculation, which includes all purchase and redemption charges.|
|14||"Investment Return" would be the pre-tax return, which would include the fund's expense ratio but exclude any front-end or back-end loads or other non-recurring fees. For purposes of computing the investment return and after-tax return, we propose that funds with multiple share classes use the same class that is shown in the bar chart.|
|15||"After-Tax Return" would be the aforementioned investment return less taxes due on the fund's distributions to shareholders.|
|16||The "Index" return would be the same as is currently required; namely, the pre-tax return (assuming no expenses or other fees) on a broadly diversified representative index. Although after-tax index returns might also be desired, we are not comfortable with any current methodology to tax-effect an index's return.|
|17||The return effects of front-end and back-end loads and other non-recurring charges can be seen by comparing the Fee-Adjusted Performance figure with the Investment Return figure. The tax bite of a manager's investment approach can be determined by comparing the Investment Return with the After-Tax Return. Finally, the manager's investment performance can be evaluated by comparing the Investment Return to the Index calculation-a comparison that is not readily available under current SEC performance reporting standards that mix investment performance and fees into one calculation.|
|18||For purposes of our comment, we propose excluding those funds that could be called a "bond fund" under the informal standard used by the Commission staff (i.e., a fund that has at least 65 percent of its assets invested in fixed-income securities) and distributes dividends to shareholders at least monthly.|
|19||These returns were calculated using the After-Tax Returns Calculator on Vanguard's website www.vanguard.com) and assume the shares were still held at the end of the ten-year period.|
|20||Share classes with higher expense ratios have lower dividend distributions because such distributions represent investment company taxable income, which is net of fund expenses. As such, shareholders in classes with higher expense ratios pay less to the government in taxes but more of their potential return is paid to the fund sponsor. Capital gain distributions are not affected by expense differences and, as a percent of the fund's net asset value (NAV), should be nearly identical for all share classes.|
|21||IRC Sec. 4982. Funds with November or December fiscal year-ends can elect to use their fiscal year-end to meet the capital gain excise distribution requirements.|
|22||Certain funds will still be able to defer some gain realization into future reporting periods. For example, a December fiscal year-end fund might realize gains in November or December but not distribute these gains until the following year in the form of a supplemental capital gain distribution.|
|23||Rule 482 under the Securities Act of 1933.|
|24||Our suggestion is to use IRS Form 1099-DIV as a pro-forma document detailing those features that must be incorporated into the after-tax return calculations. Technically, Form 1099-DIV is computed on a calendar year basis for individuals, but after-tax returns may be required for periods that may not correspond to a calendar year.|
|25||Ordinary dividend distributions reported on IRS Form 1099-DIV are "grossed-up" for any foreign taxes paid for which the fund elects flow-through treatment.|
|26||We would recommend that funds have the option of including an adjustment for foreign tax credits because not doing so would only lower the fund's after-tax return.|
|27||For example, assume a 40% tax rate, a $95 income distribution amount and $5 foreign tax paid. The grossed-up distribution would be $100, resulting in a tax liability of $35, which represents the 40% tax rate applied to the grossed-up amount less the $5 credit available for foreign taxes paid. Thus, the after-tax reinvested distribution would be the $95 distribution minus the $35 tax liability, or $60.|
|28||These calculations may need to be modified if tax laws are changed in the future. Specifically, the tax liability upon redemption should be tied to how a taxpayer would compute the liability based on Schedule D (Capital Gains and Losses) of IRS Form 1040.|
|29||See Bergstresser and Poterba, Ibid. Also, Michael Barclay, Neil Pearson, and Michael Weisbach, "Open End Mutual Funds and Capital Gains Taxes," Journal of Financial Economics 49 (1998), pp. 3-43.|
|30||Bergstresser and Poterba, Ibid.|