Avoiding Tax to the Max


By Palash Ghosh When investors were racking up big gains in the late 1990s bull market, tax efficiency might not have topped their list of priorities. After all, when you're raking in annual returns of 30% or 40%, Uncle Sam's bite doesn't hurt so much. Now that investors may have entered a period of more modest returns, however, tax-smart investing is looking more important.

Although there are hundreds of so-called tax-managed mutual funds, including those portfolios whose prospectuses don't specifically mandate tax efficiency, they essentially follow the same simple strategy: Maximize aftertax returns and minimize taxable gains. In some funds, such as Vanguard Tax-Managed Balanced (VTMFX), the strategy is even more obvious -- the portfolio has more than half its assets in municipal bonds, which has helped it achieve excellent tax efficiency.

REALIZED VS. UNREALIZED. The principal guiding mantra behind all tax-managed funds is modest

turnover. The fewer trades a manager makes, the fewer taxable gains he or she incurs. As a result, tax-efficient managers seek to invest for the long term, keeping a core portfolio of holdings while occasionally selling losing stocks and capturing losses in order to offset taxable capital gains. The idea is to keep capital gains distributions at a minimum and aftertax returns at a maximum.

When a portfolio manager sells a stock that has been held for less than a year, it realizes a short-term taxable capital gain. If the stock was owned for more than one year, the gain is classified as long term. Given that long-term gains are taxed at only 15%, vs. 35% for short-term gains, managers feel compelled to avoid, or minimize, short-term gains.

In short, fund managers face the challenge of balancing potential returns from their holdings against the possible tax liabilities incurred when the fund must distribute capital gains and income to shareholders. Capital gains distributions represent net gains on stock sales. Such gains are "unrealized" until stocks are actually sold, and "realized" thereafter. Unrealized gains are not taxable, while realized ones are. These distributions typically come at yearend and may comprise both long-term and short-term portions.

WASH-SALE RULE. A key ingredient in tax-managed strategy lies in the often-misunderstood concept of "harvesting losses." It entails disposing of losing or poorly performing stocks in order to offset taxable capital gains and reduce distributions.

In some cases, the manager may sell a stock to realize a loss, wait 31 days, as prescribed by IRS rules, and repurchase the same security, if the manager likes it. Known as the wash-sale rule, it prevents the loss from being immediately claimed for tax purposes. Such "farming of losses" helps investors mute future tax liabilities, preserve capital, and take a tax loss by offsetting gains in the future.

"In any reasonably diversified portfolio, you will make mistakes," says Duncan Richardson, chief equity investment officer at Eaton Vance and manager of several of the firm's tax-managed equity funds, including Eaton Vance Tax-Managed Growth 1.1/A (ETTGX), which has a strong long-term record with excellent tax efficiency. "The important thing is not to let those disappointments become disasters."

NEW WRINKLE. The firm's sell discipline calls for putting its losers up for sale when the price declines 10% from the initial purchase cost. "We take the loss and can use that to offset other gains within the portfolio and minimize distributions. However, gains and losses are not necessarily linked. We take the losses when we have them -- we may or may not be taking gains concurrently." The firm has had to make some small income distributions, but not capital gains distributions in any of its tax-managed funds.

The Jobs & Growth Tax Relief Reconciliation Act of 2003 introduced a new wrinkle to tax-efficient investing by lowering the tax rates on both short-term and long-term capital gains, as well as on qualifying stocks dividends. The rate on short-term gains declined to 35%, from 38.6% (the ordinary income rate), while the tax burden on long-term gains fell to 15%, from 20%. Taxes on stock dividends decreased to 15%, from 38.6%, except for nonqualifying securities like real estate investment trusts, or REITs.

"Most tax-managed funds had previously avoided dividend-paying companies, due to the 35% ordinary income rate," noted Rosanne Pane, mutual fund strategist at Standard & Poor's. "With the recent tax changes, qualified dividends are now taxed at the 15% rate. This becomes important in today's market. In the mid-to-late stages of a recovery, growth decelerates, and high-quality, dividend-paying companies tend to do well relative to more aggressive names."

LONG-TERM ADVANTAGE. Scheduled to expire in December, 2008, the Tax Relief Act's impact on the appeal of tax-managed funds remains ambiguous. "Tax-managed funds are not as attractive to investors now because of the Tax Relief Act, which diminished the advantages of taking investment risks to gain tax-efficiency," says Louis Harvey, president of Dalbar Inc., a Boston-based mutual fund consultant. "There is no particular incentive to buy a tax-managed equity fund now, with flat markets and lower taxes. These days it doesn't make any sense to lose the performance to gain the tax advantage."

However, Richardson believes the Tax Relief Act spelled good news for tax-managed funds. "What few people realize was that the differential between the tax rates on short-term and long-term gains actually widened [to 20%, from 18.6%]. Tax-efficient managers are trying to take advantage of this differential. This reinforces the need to manage for capital-gains purposes, and to avoid short-term capital gains. Where possible, make them long-term; and where possible, make them unrealized."

Mark Shank, co-manager of Loomis Sayles Tax-Managed Equity Fund (LSCGX), notes that "essentially, on long-term gains, investors are keeping 85%, whereas on short-term, they are only getting 65%. So that's a substantial tax savings, making tax-efficient funds more attractive.

TAX-MANAGED STANDOUTS. So how have tax-managed stock funds been rewarding investors on an aftertax basis of late? For the five-year period ended Mar. 31, the average tax-managed fund lost 1.4% on an annualized basis, less than the 2.3% loss for the average domestic equity fund, according to data from Standard & Poor's. For the three years ended in March, tax-managed funds rose 2.1%, vs. a gain of 3.4% for the average domestic equity fund. For the one-year period, tax-managed funds gained 2.7%, vs. a gain of 3.4%.

Richardson noted that "tax-efficiency goes in and out of vogue with investors, depending on where we are in the investment cycle." He expects stock market returns in 2005 to finish strong with probable high single-digit, or low double-digit, returns, as long as earnings remain good and interest rates don't surge too high. "In that event, tax efficiency will likely again come into investors' focus."

The tables below list the five top-performing tax-managed stock funds on an aftertax basis for the one-, three-, and five-year periods ending Mar. 31. All of the funds, with the exception of Alpine Dividend Dynamic Fund and Bridgeway Small-Cap Value Fund, are ranked 4 STARS or 5 STARS by Standard & Poor's. Both the Alpine fund and the Bridgeway fund are not currently ranked by Standard & Poor's.

Top Tax-Managed Equity Funds for 1-Year Period

FUND

Aftertax Return (%)

Expense Ratio (%)

Turnover (%)

DFA Invest Grp Tax Managed International Value (DTMIX)

12.7

0.65

7

GMO Trust Tax Managed International Equities/III (GTMIX)

10.9

0.69

36

Alpine Dynamic Dividend Fund (ADVDX)

10.4

1.35

194

Bridgeway Fund: Small Cap Value/N (BRSVX)

10.2

0.94

20.5

Dryden Small Cap Core Equity Fund/Z (PSQZX)

9.9

1.06

59

Top Tax-Managed Equity Funds for 3 Years

FUND

Aftertax Return (annualized %)

Expense Ratio (%)

Turnover (%)

DFA Invest Grp Tax Managed International Value (DTMIX)

14.7

0.65

7

GMO Trust Tax Managed International Equities/III (GTMIX)

14.3

0.69

36

Century Small Cap Select/Institutional (CSMCX)

13.6

1.13

103

Bernstein Fund: Tax Managed International Value Port (SNIVX)

10.5

1.24

71

Dryden Small Cap Core Equity Fund/Z (PSQZX)

9.8

1.06

59.9

Top Tax-Managed Equity Funds for 5 Years

FUND

Aftertax Return (annualized %)

Expense Ratio (%)

Turnover (%)

Century Small Cap Select/Institutional (CSMCX)

16.9

1.13

103

Van Kampen Global Franchise/C (VGFCX)

11.3

2.26

10

Dryden Small Cap Core Equity Fund/Z (PSQZX)

10.2

1.06

59

GMO Trust Tax Managed Small Companies/III (GTMSX)

9.7

0.7

66

GMO Trust Tax Managed International Equities/III (GTMIX)

7.7

0.69

36

Ghosh is a reporter for Standard & Poor's Fund Advisor


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