Bonds are the new stocks. Real estate is the new technology. Investors frequently go in and out of sectors as if it were fashion. But one area of investing that's tragically (and perennially) un-hip is the idea of tax management.

And just like the fashion victims who spend way too much money only to end up looking foolish, investors chasing trends ignore what might be the single most important guarantee of better-than-average returns: tax efficiency. A new study by Lipper, a Reuters company, shows that investors needlessly give up as much as 23% of returns to taxes.

The study is the first based on the disclosure requirements of the Mutual Fund Tax Awareness Act, which was passed in 2000 but only recently enacted. As of February 2002, all mutual fund prospectuses (except those for money market funds) must report after-tax returns. The results were surprising.

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"We knew going into it that taxes were a burden on the individual investor," says Tom Roseen, a research analyst at Lipper, who co-authored the study with Lucas Garland. "But we didn't expect the burden to be this great."

Investors, on average, give up 1.3 to 2.5 percentage points annually to taxes. That translates to as much as 23% of the return (in dollars) getting wiped out by taxes every year. Remember, we're talking about the capital gains taxes that are generated within the fund, not the taxes you would owe on selling the fund.

Fund expenses have long been known as a drag on returns. The average expense ratio is 1.25%, and while index and bond funds generally have much lower expenses, specialized stock funds frequently have expenses upwards of 3%. The detrimental effect of poor tax management, though, is considerably greater than the impact of expenses.

The Gift That Keeps on Giving

The beauty of compounding has been hailed in every article on retirement planning. Compounding, though, works both ways, and taxes are a significant drag on fund performance that only gets worse over time.

A KPMG study, quoted in the Lipper research, found that the median tax loss was 2.7 percentage points a year. That's pretty significant over a 30-year period.

In one example, Lipper calculated that a $10,000 investment would grow to $174,494 after 30 years, assuming a 10% average annual return. But if you factor in the median tax loss from the KPMG study, the future value of that investment would be $82,792 -- a loss of more than $91,700 just from taxes.

And lest you think that the mandate of tax management means managers are limited in their decisions and therefore aren't able to achieve the highest possible returns, Lipper's study showed that tax-managed fund performance soundly beat that of other actively managed funds.

Tax-managed large-cap, small-cap and multi-cap funds outperformed the average nontax-managed funds in the categories -- and by no small amount. The average tax-managed fund in each of the categories beat the nontax-managed funds by a range of 3 percentage points to 3.65 percentage points on an after-tax basis.

Also, the tax-managed funds kept between 77.6% and 90.4% of their gross return, whereas the average nontax-managed fund kept just 60% to 63.2% of its gross return.

Prior to the new disclosure rules, turnover was thought to be an appropriate proxy for the tax efficiency of a fund. Since high turnover typically generates high capital gains, the approach isn't totally misguided. But careful buying and selling can add to tax efficiency, even if trades are frequent. The Lipper study found that there's at least a 1-in-10 chance that a fund with high portfolio turnover is in fact tax efficient.

Small Slice

Granted, tax-managed funds make more of an impact in taxable accounts -- investors don't owe capital gains taxes on funds held through their 401(k)s, IRAs or other tax-deferred accounts.

But of the approximately $2.91 trillion invested in taxable accounts, only $35.7 billion is invested in tax-managed funds. That means just 1.2% of assets in taxable accounts are in tax-managed funds. The figure excludes index funds, but even after adding the $415.4 billion invested in index funds, that still means that only 15.5% of investable assets are in tax efficient funds.

Investor reluctance to choose tax-managed funds, whether actively managed or indexed, is somewhat baffling. Now that the disclosure requirements include after-tax returns, though, Roseen expects investors to show more of an interest.

"People tend to think there's nothing they can do about taxes, that Uncle Sam just digs into their pockets," Roseen says. "But portfolio management really can make a difference. And now we know just how much."

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