BW Online | August 29, 2001 | Taxing Times for Mutual Funds

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AUGUST 29, 2001

NEWS ANALYSIS

Taxing Times for Mutual Funds
Later this year, when SEC regulations oblige managers to report after-tax performance, Uncle Sam's slice may come as quite a shock

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For much of the late 1990s, investing in the stock market was nearly a sure thing. During those heady years, the tax burden related to capital gains on mutual funds seemed inconsequential. After all, what were a few bucks thrown to the tax man when a fund was raking in astronomical gains?

Nowadays, though, taxes on mutual funds are harder to bear. Estimates suggest that on average, taxes take off some 2.5 percentage points from a fund's total annual return -- whether it's a 50% gain or a 5% gain. The result: What once seemed like a drop in the bucket can now seem like a pound of flesh, now that the stock market has stopped soaring.

In short, no one can overlook tax consequences. "The days of 100% gains are behind us. We're in a time of more rational returns," says Bill Harding, a fund analyst at Morningstar. The tax cost means a lot more if funds are bringing back 8% to 10% vs. 60% a year." After all, the most successful domestic-stock fund category, small-cap value, is up just 13% year-to-date.

KNOWLEDGE IS POWER. Even if you're not convinced you need a fund that specializes in managing tax consequences, new regulations are almost certain to put tax efficiency in the spotlight. With the advent of new Securities & Exchange Commission rules, investors will soon be able to easily get data on pretax and after-tax performance of all mutual funds. By the end of 2001, mutual-fund companies will have to report standardized after-tax results in their prospectuses and advertising materials. This should be an eye-opener since it will make the net performances of most funds look far less attractive.

Mutual funds are required to distribute capital gains (profits from stocks that appreciate) to shareholders each year. Nontaxable fund investments, like IRAs and 401(k) plans, are not affected by this requirement, but many investors own funds outside the confines of their tax-advantaged retirement plans. Capital-gains distributions are a big cost to investing in mutual funds, and the year 2000 was one of the worst for this investing expense. When growth funds had huge gains in '99, a lot of fund managers sold in 2000 to lock in the profits. By midyear, as the market and the economy were slumping, selling accelerated as fund managers sought to stem losses. And as redemption demands increased, fund managers had to sell profitable stocks to raise cash.

The tax hit that many a shareholder took in 2000 helps explain why interest in so-called tax-managed funds has risen this year. These funds aim to keep a grip on tax consequences by limiting the number of capital-gains distributions. Tax-efficient funds hold shares for longer periods of time so they will be taxed at lower long-term capital-gains rates rather than the higher ordinary rates paid when stocks are sold after being held for a year or less. Tax-managed funds also focus on ways to sell stocks at a loss to offset capital gains.

UPS AND DOWNS. "Taxes do matter," says Don Peters, portfolio manager for T. Rowe Price's tax-sensitive funds. Peters' funds have had mixed records. Year-to-date, T. Rowe Price Tax-Efficient Balanced Fund (PRTEX ) is down some 5%, while others in the category of domestic balanced funds are down about 3%, according to Morningstar. On the other hand, the T. Rowe Price Tax-Efficient Growth Fund (PTEGX ) is down 13% so far this year vs. an average 22% decline for large-cap growth funds during the same period.

Many of the 65 tax-managed funds on the market are showing uninspired year-to-date returns as they struggle to beat the broader stock-market decline. For example, the Eaton Vance Tax-Managed Growth Fund (EXTGX ), is down some 14% this year. But that fund is up about 14% over the past five years.

Balanced funds, which consist of 60% equities and 40% bonds, are typically difficult to navigate through tax repercussions since U.S. bonds are taxable holdings. Tax-efficient balanced funds, however, reduce their tax effects by loading up on municipal bonds, which are not taxable. Of this group, Vanguard Tax-Managed Balanced Fund (VTMFX ) is a standout. It has bested 85% of its peers in after-tax results over a 5-year period.

PICKING A WINNER. Harding of Morningstar points to a couple of value funds that keep tax efficiency among their investment goals. The Third Avenue Small-Cap Value Fund (TASCX ) is up about 16% so far in 2001, while small-cap value funds on average are up about 13% in the same period. The Muhlenkamp Fund (MUHLX ) is a mid-cap value fund that has risen about 9% this year, while the category is up only about 4%. The fund has gained more than 19% the past five years. Investors should gauge a tax-managed fund like any other fund, looking closely at long-term performance and the fund manager's investing style. "Don't just buy a fund because it says it is tax-managed," notes Joel Isaacson, a New York-based financial planner. Often tax-managed funds require a minimum investment period of five years and penalize early redemptions. Some also require a hefty minimum investment. Vanguard's balanced fund, for example, requires $10,000 at the outset.

"In the long run, though, tax-managed is a very good idea," says Sheldon Jacobs, editor of No-Load Fund Investor. The spiraling economy and beaten-up stock market make tax-sensitive funds a smart holding for the long-term investor.

By Amy Tsao in New York
Edited by Beth Belton

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