Mutual Funds For The Tax-Conscious Investor

It’s probably too late for investors to trim 2010 taxable distributions generated by their mutual funds, but switching to funds that minimize taxes could come in handy should tax rates rise in the future.


December is typically when funds send shareholders the tax bill for any stocks they’ve sold for a profit and dividend income they’ve paid out.

Tax-managed mutual funds, offered by about a dozen fund firms, are designed to limit these liabilities by taking tax consequences into account when buying and selling stocks. These funds aim to sell stocks at lower, long-term capital gains rates, harvest losses to offset gains, and limit income not taxed at the 15 percent qualified dividend rate.

Judging tax-managed funds by their tax-cost ratio, a statistic used by fund researcher Morningstar to gauge how much a fund gives up in taxes, can help determine if these funds are really doing their jobs.

The 25 tax-managed U.S. stock funds tracked by Morningstar have mostly performed as advertised, giving up an annual average of 0.46 percent of their assets to taxes over the last five years compared to a tax-cost ratio of 0.84 percent for all U.S. stock funds. Tax-managed funds that invest in foreign stocks have been less effective, surrendering more to taxes than the average international stock fund.

Despite their overall success, some critics don’t see the advantage of owning a fund designed specifically to limit taxes.

Judging them by their tax-cost ratio, a statistic used by fund researcher Morningstar to gauge how much a fund gives up in taxes, provides a clearer picture of whether these funds are really limiting taxes.

“I haven’t found too many tax-managed funds that I like,’’ says Bard Malovany, a financial advisor with Sagemark Consulting in Annandale, Virginia.

He favors well-managed funds like Columbia Value & Restructuring and Fairholme that tend to be tax efficient as a byproduct of their investment process.

Year-End Investing Tax Tips  -  A CNBC Special Report
Year-End Investing Tax Tips  -  A CNBC Special Report

A fund’s effectiveness in limiting taxes is most easily measured by comparing its pre-tax and after-tax returns. But as Morningstar senior analyst Christopher Davis explains, “Past tax efficiency is no guarantee of future tax efficiency.”

In low-return markets like the one we’re in now, potential capital-gains exposure may be a better indicator of a fund’s future tax efficiency.

Most stock funds suffered steep losses in 2008 and early 2009 that have been used to offset any gains in 2009 and 2010. Some still carry enough losses to keep them from paying out taxable gains for years to come. This environment has skewed the effectiveness of tax-managed funds.

“In a low- or no-gain environment, some funds will look more tax efficient,’’ says Duncan Richardson, chief equity investment officer for Eaton Vance, which offers nine tax-managed funds. “The problem [of tax efficiency] comes when there a lot of gains in the market.’’

Richardson explains that capital gains are cyclical with bull markets leading to years of high capital-gains distributions and bear markets producing periods of lower distributions. Tax-managed funds can be most effective during periods of higher distributions, he says.

Yet Richardson concedes that funds that do two things consistently well should be highly tax-efficient: buy and hold great companies for the long term and harvest losses when they occur.

The following no-load funds generally have those characteristics as well as above-average performance, below-average expenses, and low potential capital-gains exposure, making them good choices for investors looking to curb their taxes.

  • FMI Provident Trust Strategy

    Low turnover and a 10-percent bond weighting have come in handy during down years for stocks and helped this concentrated large cap growth fund deliver average annual after-tax returns of 3.34 percent over the last five years compared to annual pre-tax returns of 1.71 percernt for similar funds.

  • Dreman Contrarian Small Cap Value

    Run by famed value investor David Dreman, this fund has given up just 0.13 percent of its returns to taxes over the last five years by owning beat-up stocks with solid fundamentals and high dividend yields.

  • Primecap Odyssey Aggressive Growth

    This mid-cap growth fund sports a turnover rate of 19 percent meaning it holds onto stocks for an average of five years. Its five-year after-tax returns of 6.52 percent are nearly double the average pre-tax returns of similar funds.

  • Vanguard Tax-Managed Small Cap

    An index-type approach that matches gains and losses has kept this fund from paying out any taxable gains in its 11-year history. That’s an accomplishment in a small cap fund category that is one of the least tax efficient.

  • Vanguard Tax-Managed International

    Rock bottom turnover of 9 perecnt goes a long way for this foreign large-cap fund. It actually has a higher after-tax return than a pre-tax return over the last ten years, thanks to foreign tax credits. It also carries losses on its books that it can use to offset future gains.

  • Scout International

    Buy and hold works well in this fund which has owned about a third of its international growth stocks for more than five years, according to Morningstar. The fund’s ten-year after-tax returns of 5.73 percent are a full two percentage points higher than the pre-tax returns of its peers.

Stock index funds can also be a good option for tax-conscious investors because their low turnover keeps capital gains in check.

When gains are low or nonexistent, tax-managed funds don’t provide much of an advantage over funds not specifically managed with taxes in mind.

Nevertheless, Eaton Vance’s Richardson says tax-managed funds have a place for investors who keep money in taxable accounts.

“The only way to be certain your tax objectives are aligned with your fund’s tax objectives is to own a tax-managed fund,’’ says Richardson.