Investors have always worried about how much they make. A bigger concern, however, is how much they keep. That’s the sales pitch behind a hot category of mutual fund, the tax-efficient or tax-managed portfolio that promises returns Uncle Sam can’t sink his teeth into.
Tax-efficient offerings became the rage after last summer’s tax reform, which changed both capital-gains tax rates and the way gains are calculated.
From a marketing standpoint, the funds are genius, because no one wants to give hard-earned money to the government. From a performance standpoint, however, the jury is still out. There are about two dozen funds claiming to be tax-managed, but they are too young to have proven much.
“The question with these funds is whether the manager can achieve tax deferral without hurting performance,” says Don Phillips, president of Morningstar Inc. “You have to look at these funds on the basis of what you earn after taxes, but it’s a moot point if they can’t generate good returns before taxes.”
Clearly, managing funds with an eye toward taxes makes sense, especially in light of 1997’s rules changes. Here’s why:
Mutual funds must pass along to shareholders virtually all of the capital gains they realize in a year. Short-term capital gains–profits made on securities held less than 12 months–are taxed at the investor’s ordinary income tax rate.
The new law created a category of midterm gains–anything held 12 to 18 months–that carries a maximum tax rate of 28 percent. And gains on securities held more than 18 months are considered long term and taxed at a top rate of 20 percent.
Some funds make fast profits from quick trades. Short-term gains are a side effect. If a fund earns 15 percent for the year, but pays half of that profit in short-term gains, the real after-tax return will be closer to 12.5 percent.
Conversely, a fund that engages in a buy-and-hold strategy and keeps turnover to a minimum might have no capital gains to pass along. If the fund earns 12.5 percent, it looks worse than its heavy-trading counterpart until taxes are figured in.
“The average investor loses 1 to 2 percent of her returns to tax inefficiency each year,” says Larry Swedroe of Buckingham Asset Management in St. Louis. “But some years, and in some funds, it could be 5 or 10 percent. People are realizing that they don’t want to start out behind the 8-ball like that, which is why tax-efficiency has become such an issue.”
But just because a fund is not labeled tax-managed does not mean it is spoonfeeding money to Uncle Sam. There are plenty of funds, most notably index funds but also many low-turnover offerings, that are inherently tax efficient.
Still, just as past performance is no guarantee of future returns, tax history or low turnover rates do not promise future tax efficiency. Funds attracting a lot of new money distribute old gains among new investors, spreading their burden to look more tax-efficient. Likewise, many managers play buy-and-hold and keep taxes low so long as the market is going strong.
A downturn could end that. If the market tanked and forced managers to ditch long-held securities, investors could wind up in tax hell, with lousy performance plus a tax bill to boot.
In 1996, for example, Fidelity Magellan gained 11.7 percent (about half of the Standard & Poor’s 500), yet paid out 15.5 percent of its assets in taxable distributions, most generated when Robert Stansky replaced Jeff Vinik and altered the portfolio. Investors with Magellan in retirement plans didn’t care, but anyone with the fund in a taxable account watched the taxes wipe out their gains.
Yet tax-managed funds also will build gains over time. There is no guarantee they will not be forced to realize those profits someday, which has prompted critics to say the best time to buy these funds is early, before gains start piling up.
In addition, tax-efficient managers will have to prove they can deliver enough in pre-tax returns to make the after-tax difference. In some arenas, such as small-cap funds, fast moves and quick turnarounds are the order of the day; restricting such moves could let the tax tail wag the dog and hurt returns.
“If a fund says it is tax-efficient, delve a bit deeper into the process,” says Michael S. Dunn of Hauswirth & Dunn, a San Francisco investment advisory firm. “Find out how they do it. Make sure they take deliberate steps to do this and aren’t just tax-efficient by accident.”
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Charles A. Jaffe is mutual funds columnist at The Boston Globe. He can be reached by e-mail at jaffe@globe.com or at The Boston Globe, Box 2378, Boston, Mass. 02107-2378.
