You Should Be Tax-Aware, Even If Your Fund Isn't

There's always something to grumble about when it comes to taxes. For mutual fund shareholders, the subject can be particularly frustrating since the tax consequences of a portfolio manager's investment decisions are completely beyond their control.

In a robust bull market with outsized gains, investors might be willing to overlook a number of return-whittling ills, such as fees or taxes. But this tax season, many are getting a reminder that taxes do count. Just ask anyone suffering the cruel irony of a hefty capital-gains distribution by a fund that ended the year in the red.

Maybe you couldn't care less about taxes because your funds are in a 401(k), IRA or other tax-deferred vehicle. OK, point taken. But the person sitting next to you probably does care, since tax-deferred plans account for only about 30% of mutual fund assets and slightly more than half of equity fund assets.

Always eager to exploit a new marketing niche, the mutual fund industry has trotted out so-called tax-managed or tax-efficient mutual funds at a brisk pace. And investors are buying: Assets in tax-managed mutual funds have grown from $867 million in 1994 to $15.3 billion now, with 50 funds for investors to choose from, according to fund-tracker Morningstar.

Such funds keep tax bills at a minimum by

• Investing in low- or no-yield growth stocks to avoid dividends.

• Buying stocks for the long haul and trading infrequently, maintaining a low portfolio turnover.

• "Harvesting" losses -- selling stocks trading below cost -- to offset gains.

• When selling winners, choosing shares held long enough to qualify for the lower, long-term capital-gains tax rate, if possible. Or selling the most expensive shares first to pare gains.

• Hedging against a volatile market with puts instead of going to cash and realizing gains.

• Restricting shareholder redemptions with penalties to avoid realizing gains.

Not surprisingly, Vanguard excels in keeping tax expenses down. Its (VMCAX)Tax-Managed Capital Appreciation fund, for example, slaps a redemption fee on anyone who wants to bail out in less than five years. And while it loosely tracks the Russell 1000 index, it screens out the highest-yielding half. Its three-year average annual return is a not-too-shabby 23.42%, or 23.13% after taxes.

But can funds that practice these strategies generally hand over higher returns to shareholders? A recent study argues yes, with qualifications.

The KPMG Peat Marwick study, commissioned by Eaton Vance, found that for the 10-year period that ended Dec. 31, 1997, the median mutual fund lost 2.6 percentage points of return a year to taxes. Folding some of the above strategies into a hypothetical example, the study found that after 10 years, a $10,000 investment in a tax-managed fund would deliver $1,890 more than an equivalent investment in a conventional fund. (The example assumes both funds return 10% a year before taxes.) After 20 years, the tax-managed fund beats the conventional fund by $10,851.

You might argue, of course, that it does little good to squeeze another 2.6 percentage points out of a fund whose return might be dismal to start with. Can tax-managed funds compete with the best performers? The category doesn't have a long enough track record to say authoritatively. But KMPG looked at the long-term records of funds that have been historically tax-efficient and found that 86% landed in the top half of the overall fund universe after taxes;70% made the top quartile.

Financial planner Harold Evensky in Coral Gables, Fla., doesn't put much stock in studies. "It's an 'emperor has no clothes' story," he says of tax-managed funds. Cutting portfolio turnover really doesn't put a significant dent in taxes until you drop below 15% or so, Evensky claims. (The tax-managed average is 35%.)

And would you really want your portfolio manager to hang onto a dog for a few more months just to get a tax break? "The market volatility in a day will overcome any tax efficiencies," says Evensky.

Are tax-managed funds merely the latest fad? I think they'll prove themselves to be a useful product for an overlooked constituency. But there are other choices -- and there have been all along. Among them:

Closet tax-efficient funds. They're not labeled so, and they have no mandate, but many funds are de facto tax-managed funds. These funds' miserly distributions keep pretax and aftertax returns very nearly even. Take a look at the table below.

Out of the Closet Tax Efficient Funds Unmasked Fund Pre-tax return* After-tax return* (TAVFX)Third Avenue Value 16.82% 16.0% (MUHLX)Muhlenkamp Fund 21.38% 21.23% (WPVLX)Weitz Partners Value 29.3% 26.73% (BARAX)Baron Asset 11.44% 11.41%

Source: Morningstar; *3-year average

The catch with de facto tax-efficient funds is that there's no guarantee that past efficiencies will be repeated in the future.

Index funds. Because of their low turnover, index funds are by nature tax-efficient. And you can assume they'll remain so. But there's a caveat: In a market downturn, managers might sell shares with huge capital gains to meet redemptions.

SPDRs. Known as "spiders," Standard & Poor's depositary receipts are unit trusts that trade on the American Stock Exchange and track the S&P 500. But unlike with index funds, buying and selling decisions are completely up to you, so you needn't worry about getting socked with gains when you weren't expecting any.

Looking at the options, I can't help asking: Why aren't all mutual funds more tax efficient? "Most managers don't give a hoot about taxes," says KPMG financial planner Rande Spiegelman. Morningstar analyst Russel Kinnel agrees: "They don't even know the tax consequences of their funds. You ask 'em, and they say, 'I dunno -- go ask accounting.'"

Granted, if I'm a 401(k) investor, I don't want my manager sacrificing anything to goose aftertax gains. But is it too much to ask a manager who's selling stock anyway to select shares with an eye to saving some tax dollars?

Maybe the problem is that not enough investors are asking. That may change soon. Next week, Rep. Paul Gillmor (R., Ohio) and co-sponsor Edward Markey (D., Mass.) will introduce legislation to increase disclosure of aftertax returns in prospectuses, annual reports and elsewhere. Watch for the Mutual Fund Investors Tax Awareness Act.

Then again, given the time of year, maybe you don't exactly need any more tax awareness right now.

>To order reprints of this article, click here: Reprints