When a fund’s manager factors taxes into investment decisions,
investors should do better.

A Taxing Problem

BY PETER D. FLEMING

ach January millions of mutual fund investors open their 1099s to face the grim news of how much taxable income and gain they will have to report. But in the past five years no new type of fund has provided more good news for certain investors than tax-managed mutual funds.

When an investor holds mutual funds outside IRAs and other tax-deferred retirement accounts, the cost of maintaining such investments includes taxes as well as commissions and management fees. Many mutual fund shareholders find taxes on interest, dividends and realized gains are the largest cost they face. With most distributions reinvested in additional shares, investors have to dig deep into their pockets to pay the tax bill.

Each year, fund sponsors introduce hundreds of new mutual funds. (Today there are more than 10,000 funds in existence.) For tax conscious investors, tax-managed mutual funds are one solution to the problem of taxable mutual fund distributions. These funds seek to invest in a way that will minimize taxes and maximize long-term growth. With tax rates on net investment income and realized short-term gains as high as 39.6% and realized long-term gains taxed at a top rate of 20%, investing in a tax-managed fund can help an investor protect a substantial portion of his or her investment return.

Although there are fewer than 100 tax-managed mutual funds (see exhibit 1 for a sampling), their stated goal of reducing the impact of federal and state income taxes on fund returns gives clients who already contribute the maximum amount to tax-favored IRAs or 401(k) plans another low-tax way to invest in the stock market.

As CPAs try to keep pace with the best investment vehicles to help clients realize their goals, tax-managed mutual funds are an increasingly important way clients can hold down taxes, leaving more for retirement, college funding and other key objectives. Here are some of the things CPAs will want to know about tax-managed mutual funds before recommending that clients add them to their portfolios.

LOW-TAX INVESTING

Tax-managed mutual funds operate the way most other mutual funds do. The difference is in how the funds are managed: Most fund managers tend to sell stocks with the lowest cost basis—and the highest profit—to boost returns, but tax-managed fund managers follow a different strategy, emphasizing aftertax returns.

The aftertax return an investor earns from a mutual fund investment is a function of four factors:

• The investor’s own tax circumstances (tax bracket, filing status).

• The pretax returns the fund earns.

• The fund’s tax efficiency.

• The investor’s time horizon.

Tax efficiency is determined by the makeup of the fund’s returns. A typical equity fund has realized short-term gains and investment income that are taxed as ordinary income (maximum rate, 39.6%); realized long-term gains that are taxed at favorable capital gains rates (maximum rate, 20%); and unrealized capital gains that are not currently taxable. A tax-efficient fund has more long-term capital gains and less investment income and short-term gains.

To avoid having to pay taxes at the fund level, a mutual fund must distribute a minimum of 90% of its income (net of fund expenses) and realized capital gains to shareholders. An investor pays taxes on all distributions, whether he or she elects to take them in cash or reinvest them in additional shares. (For more on the taxation of mutual fund distributions, see “Mutual Fund Tax Trap.”)

Taxes have a substantial negative effect on mutual fund returns. For example, if an equity fund returns 10% in a particular year, deriving 3% of that return from dividends and short-term gains, 5% from realized long-term gains and 2% from unrealized gains, its return shrinks to only 7.8% after federal taxes, as shown in exhibit 2. That means 22% of the fund’s return has been lost to taxes—before even considering the impact of any state or local taxes. (In high tax states such as New York or California investors see their return shrink even more.) Although most mutual fund managers pay little attention to how taxes can cut into a fund’s return, tax-managed fund managers must balance investment and tax considerations and evaluate how their trading will affect a typical shareholder’s tax liability.

A mutual fund’s turnover rate—how frequently the fund manager buys and sells securities—has a substantial impact on an investor’s aftertax return. Tax-managed funds generally have low turnover rates. Since most fund managers look to maximize pretax returns, they don’t even consider the tax impact of their trading frequency. The result is that an investor’s aftertax returns can be significantly lower than the fund’s advertised pretax returns.

Lipper Analytical Services, Inc., says the annual portfolio turnover rate for the average equity fund is 86%; for the average growth fund, the rate is 81%. A high turnover rate means there is the potential for the fund to realize more taxable gains. According to Morningstar, Inc., the average diversified equity mutual fund gained 14.3% in 1998 and lost 12% of that return to taxes. In contrast, the average tax-managed fund gained 21.57% in the same period and lost only 1% to taxes.

MEASURING UP

Historically, mutual fund performance has been measured by pretax returns. But with approximately 60% of mutual funds in taxable accounts, this may not be the best way to judge true performance. With the tremendous stock market gains in the latter part of the 1990s and after several years of record mutual fund distributions, investors have become more conscious of aftertax returns.

Despite the option to follow tax-efficient strategies when investing in individual stocks and bonds on their own, many investors prefer the ease of mutual funds—professional management, greater diversification, improved liquidity. A tax-managed fund, with a low turnover rate, can significantly increase returns. As exhibit 3, below, illustrates, if a high-bracket investor holds a high-turnover stock fund for 30 years before selling it, a $25,000 investment might grow to $187,888. However, if the same investor uses a low-turnover fund, the same investment could grow to $335,930.

Exhibit 3: Tax-Managed vs. Non-Tax-Managed Funds

Assumptions: $25,000 investment. 10% annual rate of return. 8% annual turnover in buy-and-hold account. 81% annual turnover in high-turnover account. Taxes are paid out of account each year, with remaining income invested in additional shares. After year three, annual distributions are assumed to be 50% ordinary income and 50% long-term gains. 20% long-term capital gain rate upon redemption. Source: State Street Research, Boston.

Even Congress is concerned that high pretax returns may be overstated and potentially misleading to investors. The House of Representatives is considering a bill to require fund sponsors to make improved disclosures. (See “Congress Chimes In,” for more details.)

SEC Chairman Arthur Levitt, Jr., is also speaking out on the tax implications of mutual fund investing. Many investors “lack a clear understanding of the impact taxes have on their mutual fund returns,” he says. In a February speech before the Mutual Fund Directors Education Council, Levitt cited the estimated $34 billion that stock and bond fund shareholders paid in taxes on fund distributions in 1997. On March 15 the SEC issued proposed rules requiring companies to disclose aftertax returns in fund prospectuses. Funds would not be required to include aftertax returns in advertising or other sales materials. The deadline for commenting on the proposed rules—available at www.sec.gov/rules/proposed/33-7809.htm—is June 30.

THE RIGHT STRATEGY

How does the manager of a tax-managed fund go about minimizing taxes? For example, here are some techniques Eaton Vance Tax-Managed Emerging Growth Fund says it uses to achieve tax-efficient management. The fund

• Invests primarily in lower-yielding growth stocks.

• Employs a long-term approach to investing.

• Tries to avoid net realized short-term gains.

• When appropriate, sells stocks trading below their tax cost (basis) to realize losses.

• When selling appreciated stock, it selects the most tax-favored share lots (those with the highest cost basis).

• Selectively uses tax-advantaged hedging techniques as an alternative to taxable sales.

Other funds employ similar strategies. State Street Research Legacy Fund uses what it calls a buy-and-hold approach to allow the fund to focus on long-term capital appreciation while reducing—although not eliminating—taxable capital gains distributions. The T. Rowe Price Tax-Efficient Balanced Fund adds tax-free municipal bonds to the mix. Its objective is to provide investors with “attractive” long-term returns on an aftertax basis with a balanced portfolio of stocks and municipal bonds. The fund invests a minimum of 50% of its total assets in tax-exempt securities.

Because large unexpected redemptions could disrupt this buy-and-hold strategy, some tax-managed funds impose a redemption penalty to discourage investors from making large withdrawals that might force management to sell securities to raise cash.

RISK AND RETURN

As with any investment strategy, tax-efficient investing carries risks as well as rewards. In evaluating tax-managed mutual funds for their clients, CPAs should use the same criteria they would use to judge any other fund, including

• The track record, background and experience of the fund manager.

• Internal fund expenses.

• Fund performance history.

• Risk relative to the fund’s peer group.

• Style consistency. (Does the portfolio stick with its selected style?)

There are, however, some special risks associated with tax-managed funds that CPAs should consider:

• Tax-managed funds are relatively new, and many have little or no track record investors can use to judge performance, risk and other factors.

• Tax-managed buying and selling might conflict with the manager’s style, reducing pretax returns.

• Over time, a tax-managed fund may accumulate a large portfolio of unrealized gains. Investors in such funds face the risk the fund will decide to realize some or all of these gains and pass them through to shareholders.

• Tax-managed funds frequently use various hedging strategies to protect gains instead of selling shares. These strategies leave the fund open to large potential losses.

• The fund’s long-term investment strategy may require it to hold a security in a down market when stock prices are declining.

It’s also important to remember that an investor who doesn’t pay Uncle Sam now is likely to have to pay later. Many tax-managed funds achieve their returns through unrealized capital gains, which means the value of the fund’s shares continues to grow. When an investor decides to sell his or her shares, the gain on disposal could be much higher than it might be with a mutual fund that had distributed its gains over time. Still, depending on the investor’s holding period, the gain on sale is likely to be taxed at favorable long-term capital gain rates. Such a scenario also puts the investor in the driver’s seat; he or she decides when to realize and pay taxes on capital gains, rather than the fund manager.

WHO ARE THEY GOOD FOR?

Tax-efficient investing isn’t good, or even necessary, for everyone. Low-bracket taxpayers generally will do better investing in more conventional mutual funds, since taxes aren’t a big concern. Tax-deferred retirement accounts also are likely to obtain higher returns from other kinds of funds since they don’t pay taxes currently. There are, however, some clients a CPA will find particularly suited to tax-managed mutual funds, including

• Tax-conscious investors who already have contributed the maximum amount to IRAs, Keoghs or 401(k) plans, or those who aren’t eligible to contribute.

• Investors seeking a flexible, more-liquid alternative to variable annuities.

• Irrevocable trusts looking for capital appreciation with minimal tax consequences.

• Those seeking funding vehicles for money transferred to children under the Uniform Transfer to Minors Act, where income earned by children under age 14 is generally taxable at the parents’ tax bracket.

• Any investors who want less taxable income, such as an older client seeking to lower his or her investment income and thereby minimize the amount of Social Security benefits subject to tax.

TAX-MANAGED, NOT TAX-FREE

When recommending tax-managed mutual funds to clients, it’s important that CPAs make sure clients understand that tax-managed does not mean tax-free. The funds seek to minimize taxes, not eliminate them. With the stock market still providing the potential for substantial gains, few investors can afford to overlook the fact that taxes reduce their mutual fund returns, and tax-managed funds provide one solution to a vexing problem. Some investors, however, still haven’t gotten the message. A July 1999 Mutual Fund Magazine survey found that taxes aren’t a concern for most mutual fund investors. In the poll, only one in eight investors put taxes near the top of a list of important considerations in judging a mutual fund’s appeal. As a result, CPAs may find they have to save these clients from themselves by educating them about the impact taxes can have on mutual fund returns. If the growing number of tax-managed funds is any indication, more and more clients are getting the message every day.