BUSINESSWEEK ONLINE : JANUARY 29, 2001 ISSUE
SPECIAL REPORT Funds That Can Dodge Tax Bullets Mutual-fund investors should also be shopping for tax efficiency Keeping mutual fund profits out of Uncle Sam's hands is tough. Even a new breed of ''tax managed'' fund--aiming to do just that by minimizing the taxable capital gains they pass on to shareholders--can miss the mark. Consider Standish Small Cap Tax-Sensitive Equity Fund. Last year it distributed a huge $17.88 a share to investors because redemptions and a portfolio revamp forced it to take unrealized gains from 1999. That turned a nasty 13.8% pretax loss into a more painful 19.2% loss after taxes. To find a truly tax-efficient fund, you have to look beyond the label and weigh the fund's track record and its underlying portfolio. BusinessWeek's Mutual Fund Scoreboard is a good place to start. The stats investors need to focus on are pretax and aftertax returns, untaxed gains, turnover, and percent change in assets. Comparing pretax and aftertax returns shows how good a fund has been at keeping the tax bite low. The closer the two numbers are, the better. Vanguard Tax-Managed Capital Appreciation Fund, for example, has a five-year annualized return of 18.8% before and 18.6% after taxes. Dividing 18.6 by 18.8 reveals that the fund is 98.9% tax-efficient. The ratio can highlight gems that aren't marketed as tax efficient but are, such as White Oak Growth Stock Fund and IPS Millennium Fund. Both have 99.7% efficiency ratios. How do they do it? White Oak's managers, Douglas MacKay and Jim Oelschlager, avoid distributions by keeping trading, or portfolio turnover, low. When stocks are held for long periods, there are fewer realized gains--and taxes are lower than on short-term gains. The fund turned over, or sold, just 6% of its portfolio in the past year. ''We're not just focused on a stock's next quarter, like some funds,'' Oelschlager says. ''Our typical holding period is three to five years.'' What managers sell, however, can be more important than how often they sell. IPS Millennium has a 52% turnover but is just as efficient because manager Robert Loest dumps his losing stocks at year-end to offset gains on winners. So, while low turnover is usually good, high turnover isn't always bad. Both White Oak and IPS Millennium had an easier time because buyers came flocking in. Funds that attract lots of new assets are inherently more efficient because the growth in assets dilutes existing gains in the portfolio, thus reducing each investor's potential tax liability. That's why White Oak could keep distributions down last year: On the Scoreboard, you'll see that its assets grew 125%. ''We've never had a real huge redemption in our funds,'' says MacKay. The catch is that the process works in reverse for funds that lose assets. A dwindling portfolio painfully magnifies the tax liabilities of investors who stay in the fund. So investors need to stay alert for funds that pile up large amounts of undistributed capital gains (table). There's no hard and fast rule, but untaxed gains should raise red flags if they top 25% of total assets. The risk is that funds with big gains in previous years can be forced to sell appreciated stock if they face shareholder redemptions, landing holders with a big tax bill, as in the case of Standish Small Cap. Some funds, such as Smith Barney Telecommunications Income and Armada Tax Managed Equity, have unrealized gains in excess of 80% (table). Any big redemptions here will likely cause large distributions and sizable tax bills. ARRIVE LATE. Tax efficiency can also be an unintended consequence of poor performance. Funds that plunged in 2000 are now tax shelters--with loads of losses that can offset gains far into the future (table). Fidelity Emerging Markets has declined so much over the years that its unrealized losses equal 181.2% of assets. Some new tech and Internet funds launched last year are now tax-efficient vehicles. Jacob Internet Fund, for instance, has losses equaling 429.4% of its assets, so it won't be making a distribution anytime soon. A fund's investment style also impacts its efficiency rating. Value and small-cap funds can be inherently inefficient: Value managers sell appreciated stocks that no longer fit their value criteria; small-cap managers sell companies that grow too big. Both strategies tend to produce more gains than losses. Of course, having no taxable distributions doesn't mean a whit if the fund's performance is bad. ''It's not about being 100% tax efficient,'' says manager Duncan Richardson of Eaton Vance Tax-Managed Growth Fund. ''It's about maximizing aftertax returns.'' But funds that both perform badly and make big distributions can be a very serious pain in the pocketbook. By Lewis Braham in New York _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ BACK TO TOP					RELATED ITEMS The Best Mutual Funds TABLE: The A List TABLE: The Best Performers in Their Categories TABLE: The Largest Funds TABLE: The Fund Categories Caution: Your Fund May Be Top-Heavy TABLE: Diversified Funds Lose on Big Bets Funds That Can Dodge Tax Bullets TABLE: Weighing Funds' Tax Baggage Commentary: No Excuse for High Fund Fees SCOREBOARD: Equity Funds: Mutual Fund Scoreboard (.pdf) Interactive Mutual Fund Scoreboard INTERACT E-Mail to Business Week Online

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