Tax inefficiency can ambush the unwary

Mutual funds

August 02, 1998|By Jerry Morgan | Jerry Morgan,NEWSDAY

Are tax-efficient funds important for investors?

Jean and Joseph Wallman of Centerport, N.Y., think so. They expected to pay capital-gains taxes earned last year on shares they sold. But, retired and living on a pension and investments, they weren't ready to pay taxes for shares their fund manager sold.

The result was a tax bill a few thousand dollars higher than expected.

"We weren't prepared to pay that much in tax," said Jean Wallman. "We had to sell other funds this year just to pay that tax, which means we will have more capital-gains taxes next year."

The general lack of concern fund managers show about the tax consequences of their investment policy is legendary, yet understandable.

"Fund managers want high performance," said Don Phillips, president of Morningstar, the Chicago mutual fund ratings firm, "because they are paid to manage for performance and they don't really care about tax efficiency. The capital-gains taxes just get passed on [to investors]. The managers buy and sell stocks when they think they should."

But that shifts control of the investor's tax bill to the manager. You may not have sold any shares last year, but you still can get a tax hit if your fund manager did.

Basically, tax-efficient mutual funds are funds that make little or no taxable distributions during the year. Funds are required to pass through to shareholders any capital gains and dividends. If you want to be tax efficient, don't have capital gains. That can be accomplished several ways. A fund manager can offset capital gains from the shares of stocks that have appreciated by selling shares that have lost money. Or a fund can have low turnover, which generally creates long-term unrealized capital gains instead of quick taxable profits. Or a fund can have a mix of taxable stocks held long term and tax-free municipal bonds.

But performance is still the key, and there is a growing reason for it: the huge flows into tax-advantaged accounts such as 401(k)s and Individual Retirement Accounts.

The issue is this: If there is so much fund money in tax-deferred accounts, why bother to tax-manage a fund in which the majority of shareholders don't pay taxes?

"We are on the verge of class warfare," said Geoff Bobroff, a mutual fund industry consultant in East Greenwich, R.I. "Everyone wants to see double-digit returns, but the goals of the two groups of investors separate. I may want minimum tax exposure, but the tax-deferred investors are saying put the pedal to the metal, load it up. I think you may see some fund splitting along those [tax-deferred vs. taxable] lines."

High returns and no tax bills can be combined. Morningstar found 11 U.S. diversified funds and four emerging markets funds had returns of more than 30 percent and no distributions last year. Nineteen tax-managed funds also had returns of 20 percent or more in 1997. But in a year when the average equity fund returned 24 percent with a wide range of distributions, there aren't many tax-efficient funds among the 7,000 out there.

Does that mean you should rush out to buy tax-managed funds? Not necessarily. "I think investors should run away from tax-efficient funds now because their returns aren't as good as other funds," said Michael Lipper, president of Lipper Analytical Services Inc.

Large capital-gains distributions don't necessarily mean funds are doing well, as owners of Pacific region and emerging markets funds have found out during the Asian financial crisis.

Dozens of funds fell sharply last summer but still had large payouts because, as the funds declined, investors pulled out, forcing managers to sell stocks to redeem shares, even if it meant big capital gains because stocks in the fund had risen. That left remaining shareholders with a tax insult to investment injury: big tax bills on funds whose shares had plummeted.

There is another reason some funds have high turnover. New managers tend to clear out stocks bought by the old manager. That means that funds are cashing in large, unrealized capital gains -- paper profits that have not been taken -- and suddenly generate large payouts after there has been a managerial change.

Pub Date: 8/02/98

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