The Daily Interview: April Really Is the Cruelest Month

This year, many investors in taxable mutual funds have not only been hit with large losses, but have also suffered the indignity of having to pay sizable tax bills on top of that bad news. Jim Blakeslee, chief tax strategist for Liberty Funds, explains how it's possible for an investor who's lost money to still owe money to Uncle Sam, and describes how tax-managed funds can help investors avoid this situation.

Jim Blakeslee Chief Tax Strategist Liberty Funds

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Liberty runs four such funds, the newest of which -- the (SRVAX Quote)Liberty Tax-Managed Value -- delivered an impressive 14.1% return in 2000.

TSC: How could investors be socked with a hefty tax bill when they ended up with less money than they started out with in 2000?

Blakeslee: The year 2000 is likely to be one of the most tax-costly years ever, because it followed such an extraordinary run up in the markets. It is very likely that many people lost substantial sums of money and are paying taxes on their fund distributions as well.

Just the other day, a financial advisor told me a true story about an investor who gave them $20,000 in 1999 to put into an aggressive growth fund. Today, that's worth $3,300 -- and they got a tax bill for $5,500.

For investors in a taxable mutual fund, there almost always are distributions from older investments in the form of capital gains and ordinary income, depending on what type of distribution it is. The distributions come as a result of the fund manager selling off positions in the fund and generating capital gains, which are then passed along to the shareholders.

Anything that's short-term is taxed at ordinary rates, and those range from a low of 15% to a high of 39.6%. So, it is conceivable for somebody who's in a very high tax bracket to have lost money, received the distribution from the fund company, and then have to pay taxes at a 40%-plus tax rate, taking both federal and state taxes into consideration.

TSC: Have taxes been increasing for investors in taxable funds and if so, why? Is it because portfolio managers are turning over their holdings more frequently, or because the markets have become more volatile?

Blakeslee: We've been running something called the Liberty Tax Pain Index to track taxable distributions on mutual funds, and the amount of taxes that people pay on those distributions. The Tax Pain Index indicates that the percentage of taxes that investors are paying has risen. In 1990, funds had $41 billion in taxable distributions and investors paid $7 billion, or 17% of the money, in taxes. In 1999, funds made $188 billion in taxable distributions and investors paid $43 billion, or nearly 23%, in taxes on that money.

Market volatility tends to create more turnover as fund managers try to reposition their portfolios, taking into consideration the marketplace. In addition, there has been an increased use of mutual funds as form of investment, replacing other instruments that previously might have been favored.

TSC: What's a tax-managed fund?

Blakeslee: Low turnover and buy-and-hold for at least one year are clearly components of a tax-managed fund. I like to refer to them as the bedrock. You get preferential treatment for long-term capital gains on the tax distributions just by doing that, since the highest short-term capital gains rate is 39.6%, while the highest long-term capital gains rate is only 20%. So you need to buy and hold or have relatively low turnover to be successful in a tax-managed fund.

But in addition to that, there's really another factor, what we call active tax management. We apply a variety of these tax techniques to our four tax-managed funds here to reduce the amount of distributions to shareholders.

We do things like tax switching and dividend rolling, which artificially create tax losses for a portfolio. We take advantage of the wash sale rules in volatile times. All of these additional techniques provide us with additional opportunities to reduce -- and in some years even eliminate -- taxable distributions to shareholders.

TSC: Could you explain one of these techniques, say dividend rolling?

Blakeslee: In the context of a growth fund, it's the conversion of an ordinary loss into a short-term capital loss. With a growth fund, there's typically not enough income to pay the expenses in the fund, so you have an ordinary expense with insufficient ordinary income.

As our fiscal year begins to wrap up, we'll go out to the marketplace and artificially buy dividends, things like utilities securities, just before the dividend goes ex. Say we buy a stock at $48 with a dividend. Fifteen minutes later, there's a dollar split off for the dividend. The stock is now only worth $47. The dividend is $1. We still own $48 of value. We simply use that $1 dividend to sop up our ordinary expenses -- because you have to match ordinary expenses with ordinary income. We then sell the stock off at $47, realizing a $1 short-term capital loss.

TSC: It sounds pretty complicated.

Blakeslee: That's true. And I think there are some people who develop tax-managed funds without the requisite experience to not only manage the investment, but to manage the portfolios for after-tax returns. Such funds are not truly tax-managed. They're simply buy-and-hold or low turnover portfolios, and that won't get them all the way there.

TSC: How much of an impact can a tax-managed strategy have on a fund's return?

Blakeslee: We believe a tax-managed strategy can improve returns by 100 to 150 basis points over a three-to-five-year period.

TSC: How popular are these tax-managed funds? Are you seeing any increase in interest in them?

Blakeslee: In the past three years, our funds have increased from $70 million in flows to almost $500 million last year. And the SEC is now starting to mandate -- effective in October this year -- that all funds post their pre- and post-tax returns.

The tax pain is going to increase, unless people take action to reduce it themselves. Nobody at Liberty is waiting for George W. Bush to reduce our taxes. I think tax-managed funds make sense for people who want to reduce their liability now, rather than wait for the government to do it for them.