HONG KONG -- Never mind that stocks in Asia are trading at valuations far lower than comparable shares in the U.S., or that the region's economies are growing faster than America's. Investors looking at the region should consider a more mundane reason for putting a portion of their money into Asian mutual funds: taxes.

For investors keen on reducing the taxman's take, Asia currently offers a variety of bargains.

Of course, tax savings alone should not be the driving factor in determining where to invest, but neither should they be ignored. The average U.S. stock fund not held in a retirement account has lost some 22% of its annual return to taxes over the last three years, according to

Morningstar

.

Every time a fund manager sells a stock at a profit, it creates a capital gain. Gains that can't be offset by losses are then passed on to the fund's shareholders, and it's up to them to deal with the tax consequences. (Dividends are passed on as well.)

Ironically, one reason Asia funds are relatively tax-efficient is that Asia hasn't been a good investment for awhile. The region's losses in recent years have made it easy to offset some of the capital gains that good fund managers rack up.

"We've benefited from the fact that there were significant losses in previous years," says Scobie Ward, manager of

(EMGIX)

Eaton Vance Greater India fund, which posted negative returns in 1995, 1996 and 1998, but finished 1999 up 105%.

Of course, there are plenty of highly tax-efficient U.S. mutual funds, often investing in municipal bonds. But those funds generally don't offer the kind of growth prospects Asian equity funds can, or the sort of diversification many investors are seeking.

There are other options. At home, Americans who buy into the

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Vanguard 500 Index fund, which tracks the

S&P 500

index, can expect not only to beat a lot of active fund managers in most years, but the fund's low turnover rate means fewer capital gains taxes to pay. The Vanguard 500 fund's tax efficiency over the past five years has averaged 96%, according to Morningstar (which assumes a 39.6% federal tax rate). That means capital gains and other taxes have only eaten away four cents of every dollar of returns.

But when actively managed funds are thrown into the mix, the average U.S. stock fund has a much lower tax efficiency of 81%. The average Pacific-wide fund's tax efficiency is slightly higher, 82.7%. But many funds in the region are able to beat that average by a wide margin, despite very active management that might otherwise be expected to produce big tax bills for investors.

The reason is that in Asia, a fund often invests in 10 or more markets, many of which are highly illiquid. Money tends to slosh in and out in great waves, and alert managers need to be ready to buy and sell at short notice, not after the indexers get around to re-weighting their indices according to market capitalization.

So while active management in volatile markets sounds like a recipe for high turnover and lots of capital gains, because of the diversification in the markets a smart manager can often come up with capital losses to offset those gains. Hong Kong's market may be up 74% in five years, but Thailand's is down 76%.

Looked at from the index fund's point of view, these differences in what is supposed to be a single region are frightening. The managers of

Morgan Stanley Capital International's

Asian indexes cut Thailand's weighting nearly in half, not so much because the stocks in the index performed badly, but because of changes in economic policy in Malaysia and Taiwan increased those markets' respective weightings. The reduction in Thailand's weighting forced mutual funds tracking the index to reduce their own holdings in Thai stocks, requiring any gains to be realized (and possibly taxed) even if it made sense to hold on to the stocks a while longer.

Little wonder that passive index investing doesn't work in Asia. The annual expense ratio of Vanguard's

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Pacific Stock Index fund, which tracks the MSCI Asia Pacific index, may be low (0.37%), but its tax efficiency is just 64%. Compare that with

Merrill Lynch's

actively managed

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Pacific Fund, which had a tax efficiency of 81%.

Indexing in Asia also fails from a raw performance perspective. Over the past year, 77% of Pacific stock funds beat the MSCI Asia Pacific index because the surge of non-indexed dot-com stocks left old indices in the dust. Only actively managed funds could get the exposure to those highfliers.

Aside from country-weighting problems, Asia also features a large concentration of ownership in some markets and that can cause problems for indexers too. A core holding of many Asian funds has been billionaire tycoon Li Ka-shing's company

Cheung Kong

, which was suddenly booted out of the MSCI Hong Kong index in May. A fund restricted to index investing would have dumped the stock and exposed itself to a big capital gains tax bill. It would have then bought internet conglomerate

Pacific Century CyberWorks

-- controlled by Li's son -- which was introduced to the index at the same time. The problem is that indexers would have only bought PCCW after it had more than doubled in less than a year. The result: a big capital gain, while missing out on CyberWorks' major return.

Another attractive actively managed fund is the

(WPJPX)

Warburg Pincus Japan Small Companies fund. Though beaten down this year, it is 96% tax efficient, the same as the Vanguard 500 fund. Over five years it has returned a pretax average of 17.9% annually, and in 1999 returned an astounding 329%.

(PIDFX)

Pioneer Indo-Asia also merits a good look because it lets investors keep every penny of income they make, and the fund returned 107% in 1999. However, the broker-sold fund comes with a large 5.75% sales charge and a 2.24% annual expense ratio that is significantly higher than average.