Excerpted from Common Sense on Mutual Funds by John C. Bogle, pages 282-283

The impact of taxes on the capital component is another story altogether. Here, tax-inefficient is the operative term for mutual funds. The tax blessing, as it were, in the income component of return is overwhelmed by the tax bane on the far larger capital component. A simple example: During the past 15 years, the average equity fund enjoyed an average annual return of 14 percent. Let's assume 3 percent of the return came from income and 11 percent from capital, of which 8 percent was realized. Let's further assume that 30 percent of the capital gain was realized on a short-term basis. (These assumptions closely parallel actual industry experience.) On the income side, the tax bite, assuming a 33 percent average rate, would reduce return by 1 percent. On the capital side, with a 33 percent rate on short-term gains taxable as income, and a 25 percent tax rate on long-term gains, taxes would claim 2.2 percent of return. In all, taxes would have reduced the reported returns of the average equity fund from 14 percent to 10.8 percent, while leaving risk unchanged.

The fact is that taxes have a hugely negative impact on relative returns. An outstanding article by Robert H. Jeffrey and Robert D. Arnott in The Journal of Portfolio Management, "Is Your Alpha Big Enough to Cover Its Taxes?" concludes that it is not. I'll add: No, your Alpha is being eaten alive by taxes. That situation is made somewhat more dire by the fact that equity funds, as we've seen, largely because of their investment costs, already have had a negative Alpha of -1.9 percent annually over the past 10 years. On an after-tax basis, that negative Alpha nearly triples to -5.1 percent. Professional investors all know that successful investing is a tough game. But fund costs and taxes, some paid unnecessarily, make it even tougher. Even if some individual investors are aware how much tougher the game is when fund expense and taxes are deducted from the manager's returns, all fund investors should be told the facts - and the figures - with candor. That 5.1 percent slice confiscated more than one-fourth of the stock market's return in the past decade.