Mutual funds that keep the tax man away

These tax-managed funds boost returns by paying less in capital-gains taxes.

By TheStreet Staff Apr 11, 2011 10:16AM

Image: Mutual funds (© ThinkStock/SuperStock)By Frank Byrt, TheStreet


The sting of taxes on mutual fund returns should be a perennial issue for individual investors, but it tends to get their attention only in April, when they see how much Uncle Sam takes.


For investors who haven't sold fund shares, it's particularly galling when their fund kicks out a taxable capital gain after booking a profit on stock sales.


That jolt often gets investors interested in tax-advantaged or tax-managed mutual funds, which strive to minimize the tax hit to shareholders by matching capital gains on stock sales with previous investment losses.


But investors' interest in such funds waxes and wanes. Investors become most interested when there is a down market after several years of strong gains and they have to pay tax on capital gains while seeing a loss in their funds. They lose interest when they're in an up market and their fund is posting big numbers.

There were 54 tax-managed funds with total assets of $54 billion at the end of 2010, according to Lipper, a unit of Thomson Reuters.


Tom Roseen, a mutual fund analyst at Lipper, said Friday that fund investors will become interested in tax-managed funds again about a year from now. That's because much of the investment-loss carry-forwards from the down markets of 2007 and 2008 have evaporated in the bull market of the past two years, and taxable capital gains distributions are going to rise at the end of this year.


"So the tax holiday will be over," he said.


But fund industry analysts say tax-savvy investing shouldn't be a cyclical consideration. "Everybody can benefit from investing in a tax-conscious manner," said Morningstar's Christopher Davis.


"I've always been puzzled by their lack of popularity," he said of tax-managed funds. "There is this misperception that if a fund is tax-managed (its investors) are getting a lesser fund with weaker returns, but that's not necessarily the case. They are a way to maximize your returns."


Those benefits can be significant, especially when compounding is added to the equation. According to Morningstar research, investors who ignored the potential tax consequences of their investment choices gave up between 1 and 2 percentage points, on average, of their annual fund returns to taxes, over an extended period.


Boston-based investment firm Eaton Vance (EV), one of the biggest proponents of tax-managed investing, with a stable of 10 tax-managed mutual funds, says that since about half of all individuals' managed assets are now in retirement accounts where tax consequences are not an issue, many fund managers "have altered their behaviors to include shortened holding periods, increased trading frequency and, ultimately, more potential capital gains distributions. The result is that taxable equity investors have been overlooked."


Duncan Richardson, an executive vice president and chief equity investment officer of Eaton Vance and a tax-managed mutual fund manager at the Boston company since 1990, says a tax-managed fund's real returns can turn out better than those that chase short-term gains, after tax-related considerations are included. And that difference really shows up over a three- to five-year period.


The Eaton Vance Tax-Managed Mid-Cap Core Fund (EXMCX) is a good example of how this works. In the first quarter, the $51 million mutual fund returned 10.9% on a pretax basis, about double the Standard & Poor's 500 Index's 5.9%. But on a tax-adjusted basis, its return was only 4.5%, meaning an investor halved his tax liability in the period. Over the year through March 31, the fund gained 31.4%, but that fell to 23.8% on a tax-adjusted basis, while over three years, the fund's pretax return was an average of 11.1%, which was 9% on a tax-adjusted basis.


The Eaton Vance fund's top holdings are Netflix (NFLX), the DVD-rental and video streaming company, up 33% this year, and Affiliated Managers Group (AMG), the owner of several money-management firms, up 12%.


In comparison, the $80 billion Fidelity Contrafund (FCNTX), which has a primary goal of providing steady returns, had a return of 4.9% in the first quarter, which was reduced slightly on a tax-adjusted basis. Over the previous year, its total return was 19.4%, which was reduced to 18.2% on a tax-adjusted basis, while on a three-year basis, the fund returned an average of 3.9%, which was reduced to 3.7% on a tax-adjusted basis.


Contrafund's top stocks are: iPhone and iPad maker Apple (AAPL), at 7.2% of the fund, and Internet search engine Google (GOOG), at 5%.


Morningstar analyst Greg Carlson cited several funds that could be attractive to investors interested in tax-efficient funds, in an April 7 article on the firm's Web site.


One is the $2.2 billion John Hancock Classic Value Fund (PZFVX), which has a one-year return of 11.3% that gets cut to 5.7% on a tax-adjusted basis. It also has a huge 110% tax-loss carry-forward that can be used to trim the tax impact of future gains.


Its top holdings are oil-industry giant ExxonMobil (XOM), at 4.8% of the portfolio, and Hewlett-Packard (HPQ), at 4.7%.

Another recommended fund is the $1.2 billion DWS Global Thematic S Fund (SCOBX), which has a one-year gain of 15.3% that is trimmed to 15% on a tax-adjusted basis. But more significantly, it has a tax loss carry-forward of 42% to take off future tax liabilities.


Its top stocks are: life-sciences products maker Life Technologies (LFE), at 2.4% of the fund, and Apple, at 2.2%.


Both Morningstar and Lipper provide information on their websites that can help investors select tax-managed funds.


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