By DAVID FRANECKI
No one likes leaving money on the table. But year in and year out, mutual-fund investors do just that in the form of capital-gains taxes. Funds handed Uncle Sam more than $150 billion from their investment gains in 1997, according to fund-tracker Morningstar, which was the biggest tax bite ever.
Opportunists that they are, more and more fund companies are rolling out offerings they claim will help cushion the blow. While picking winning stocks is still the name of the game in "tax-efficient" or "tax-managed" mutual funds, these portfolios attempt to minimize the revenuers" cut when they map their strategies. The goal: to deliver the highest after-tax gains to investors.
There are 21 U.S. diversified tax-managed funds tracked by Morningstar. Their collective asset base ballooned from $1.44 billion at the end of 1995 to more than $7 billion through February of this year. Companies peddling such products include the Vanguard Group, T. Rowe Price Associates, Charles Schwab, Stein Roe & Farnham and Eaton Vance. Even Boston fund giant Fidelity Investments says it is pondering joining the tax-friendly fraternity.
Tactics vary for keeping the tax bill low, but one tried-and-true method is simple: Buy and hold. The incentive to do so increased when the Taxpayer Relief Act of 1997 lowered the capital-gains tax rate on investments held for at least 18 months to 20%.
Thus, funds bearing the tax-efficient label generally sell less than 20% of the holdings in their portfolio within a year, compared with an average turnover rate of about 84% for typical stock mutual funds, according to Morningstar. Most tax-efficient funds will consider buying only equities that pay small or no dividends. When they do unload some shares, they try to "harvest losses" -- that is, intentionally realize a capital loss to offset capital gains.
For instance, Duncan Richardson, who runs more than $4 billion in tax-managed assets, including the Eaton Vance Tax-Managed Growth fund, generally sells a stock that has taken a 10% loss since his purchase, even if it's an issue he likes and still has hopes for. He'll then wait the mandatory 31 days to move back into the shares, to avoid violating the IRS's "wash sale" rule, which bars the taking of tax losses if, within 30 days of a sale, the seller repurchases an issue. Alternatively, he'll pick up stock in a company in the same industry and with similar characteristics.
Regardless of whether they call themselves tax-efficient, some funds are naturally so. Morningstar has been giving more analysis lately to tax issues, and its numbers show a host of funds that keep the bite from Uncle Sam, states and localities to a minimum, purely in the name of prudent portfolio management. U.S. Global Leaders Growth fund, for instance, generated no taxes over the 12 months ended in February, delivering its full 44.32% gain to investors, according to Morningstar. Same with AIM Capital Development, which shielded all of its 41.70% return from the tax man's clutches. Neither fund claims to be tax-managed.
There are some who charge that the tax-sensitive label is mostly gimmickry, and are critical of any fund that deviates from simply selecting the stocks it considers to be the very best around. Indeed, what good are low taxes if returns are low, too?
Harold Evensky, a principal at financial planner Evensky Brown Katz & Levitt in Coral Gables, Florida, which directs about $320 million of investors' money in mutual funds, is in that camp. He says a fund manager shouldn't be handcuffed by a tax-sensitive approach that would rule out a dividend-paying stock or one that mandates harvesting capital losses on purpose.
"If you like the stock, you have to stay out for 31 days," Evensky says. "There's an opportunity cost of being out of something you like."
Evensky contends that investors should pay attention to a fund's tax history before buying it, and he says many portfolio managers naturally harvest losses through conventional portfolio management. "I would expect a good portfolio manager to employ those tactics on all their funds," he says. "To me, the tax-efficient portfolio is basically a marketing ploy."
Not so, replies tax-managed fund diehard Joel Dickson, who wrote his doctoral dissertation at Stanford University on mutual-fund taxes and then moved on to cost-conscious fund giant Vanguard. "I think any way you can get higher returns for shareholders is not a marketing tool, it's a way you can improve shareholder wealth," he says.
For example, Vanguard Growth & Income Portfolio, an actively managed fund that tracks the Standard & Poor's 500 Index, has returned 32.95% annually for the last three years, but investors have taken home only 28.62% gains after taxes. Meanwhile, Vanguard's tax-managed growth-and-income portfolio -- basically an S&P 500 fund with a tax-managed tilt -- gained 32.69% annually over the same period and 31.83% after taxes, a three-percentage-point boost because it is tax-managed.
Dickson asserts that few actively managed fund portfolios give serious consideration to the tax implications of their stock trades. "Taxes and expense ratios are probably the most important things, after a well-diversified portfolio," he adds.
Still, he admits that there are a lot of myths about tax efficiency, and the effects of turnover may be one of them. For example, Stagecoach Strategic Growth turned over just 10% of the stocks it owned in the 12 months ended February, but lost nearly half of its 23.13% gain in 1997 to taxes. Such things are possible when funds unload stocks such as Microsoft, Coca-Cola and Gillette that have racked up huge unrealized capital gains in recent years. In addition, a low-turnover fund could invest in high-dividend stocks, a surefire way to jack up taxes.
"There's low turnover and then there's good turnover," says Gordon Fowler, global head of private-client investment management at J.P. Morgan.
Index funds tend to be tax-efficient because of their buy-and-hold strategy, but can't promise a low tax bill every year. Vanguard Extended Market Trust, which tracks an index of small and mid-sized companies, has returned an average of 26.3% over the last three years ended February, but a tax-adjusted return of just 24.07%. The tax-friendliness of indexes of small and mid-sized companies, in particular, are suspect because as companies outgrow the indexes, the funds are forced either to sell out of the stock and induce a capital gain, or stick with it and drift from their stated investment objectives.
Don't be fooled by funds masquerading as tax-efficient that really aren't. Most impostors get by because they're raking in new cash and can spread their gains over a growing investor base, giving the appearance of tax efficiency.
Example: The Kaufmann Fund, which soon is expected to be sold by its managers, Lawrence Auriana and Hans Utsch, is known for its aggressive growth-stock picking and even more aggressive advertising. It looks pretty tax-efficient on paper. It doesn't harvest losses and isn't known to buy and hold. But it has reeled in new assets. Kaufmann kept 96.9% of its pre-tax return over the last three years, in part because it's roughly quadrupled in size to $6 billion in the past four years during that period.
The danger of mistaking a popular fund with a tax-efficient one is that cash inflows have a way of reversing when a hot fund's performance slips. A shrinking asset base is a sure red flag for tax-conscious investors.
When investors pull money out, portfolio chiefs must liquidate shares. That often generates capital gains and hikes the tax penalty. Some companies, such as Vanguard and J.P. Morgan, charge investors a penalty for taking dollars out shortly after buying. "The one thing that kills you in a tax-managed fund is market timers," Dickson says.
While none of the funds bearing the tax-efficient label have been tested by a severe stock-market downturn, some lessons could be learned from the woes of certain international funds. GT Global New Pacific, for example, has lost 9.01% annually over the last three years ended February, but its tax-adjusted loss is worse -- 11.56%, according to Morningstar.
Although the tax-efficient fund genre is relatively new, several of its members have had notable success. For instance, J.P. Morgan Tax Aware U.S. Equity has returned an annualized 35.41% since its December 1996 inception, placing it in the top 20% of growth-and-income funds tracked by Lipper Analytical Services. And investors kept virtually all of those gains, because manager Terry Banet ran the portfolio without incurring any net capital gains and paid out only a small dividend.
But the tax-friendly picture has been obscured by the fact that commonly used performance scorecards say nothing about taxes. Mutual funds aren't required to publish after-tax returns and the major fund-trackers such as Lipper and Morningstar rank performance based on returns net of fees but not after taxes. Given that investors gave roughly twice as much to the tax man last year as they paid in management fees, traditional performance figures don't tell the whole story.
Mutual funds, by nature, aren't as tax-efficient as stocks bought directly because portfolio managers, not shareholders, make the buy-and-sell decisions without regard to the tax problems of individual holders. Selling shares is a surefire way to get whacked by taxes, assuming the fund made money, as nearly all have in recent years. What's more, buying into a fund means taking on unrealized capital gains embedded in a portfolio. If you purchase shares shortly before funds distribute their gains, as many commonly do in December, you effectively can wind up paying taxes on profits you never receive.
Ironically, the bull market is both the inspiration behind tax-efficient funds and a big reason why investors have largely ignored them. "There's no question in my mind that the focus on tax efficiency is, in part, a product of a very extended bull market," says Mike Dunn, a partner in San Francisco-based investment adviser Hauswirth & Dunn Investment Management. Many investors are no longer satisfied with robust returns, he says, "now they want a winning investment that's tax-efficient."
Yet, for many, the stock market's euphoric ride has kept tax issues a mere afterthought, notes Dunn. "There's not much differentiation between pre-tax and after-tax return because they're all huge numbers," he avers. Buying a tax-managed fund within a 401(k) or IRA plan is simply overkill, so the funds will surely miss a huge part of the fund business there.
But as time goes on, many people expect tax efficiency to become more than an afterthought. So, how do you pick a tax-efficient fund?
It's tricky, because every rule of thumb seems to have an exception. What's worse, a history of tax efficiency promises nothing about the future. Buying those with a tax-managed label may be the simplest, but requires committing to a somewhat untested strategy.
The best-performing tax-managed funds over the past 12 months are Standish Tax-Sensitive Equity Fund, Vanguard's tax-managed growth-and-income fund and Eaton Vance Tax-Managed Growth Fund. Otherwise, researching a fund's capital-gains history, turnover rate and reading its prospectus to see if taxes are even mentioned can give some clues.
Ultimately, tax efficiency should be a factor -- but not the main one -- in picking a mutual fund. Performance, riskiness and suitability are of more import to most people. Still, it's nice, come April 15, to hang on to most of your gains.