What investor should look for in funds for 401(k) or IRA?

You should seek out tax efficiency - usually

March 18, 2001|By Russel Kinnel | Russel Kinnel,MORNINGSTAR.COM

I'm often asked to recommend funds for IRA accounts or 401(k)s. Start by looking for funds you expect to produce strong performance within your risk-tolerance range. One common question is whether you should start with a list of funds that are tax-inefficient, and the short answer is no.

However, there are exceptions. Some funds are explicitly run without taxes in mind, and that's a good thing because you're after pretax returns in an IRA or 401(k). In addition, it's helpful to be aware of which funds aren't very efficient because you don't want to make the mistake of putting them in your taxable accounts. So, here are some funds to avoid in taxable accounts but consider placing in tax-sheltered ones.

Institutional funds: Institutions are taxed differently, and therefore, managers of funds designed for institutions generally ignore tax effects on their strategies. These funds often are accessible to us little guys through supermarkets or retail share classes. PIMCO, MAS and GMO run some of the better institutional stock funds, but most have lousy tax efficiency. Morningstar has MAS Mid Cap Growth (MPEGX) in its 401(k).

Enhanced index funds: Though I prefer mine unenhanced, there are some pretty good options here. PIMCO StocksPlus (PSTKX) has managed to outperform most S&P 500 funds with a strategy of buying futures and then making modest bets on short-term bonds. The fund trails the S&P 500 by only 0.03 percent per year over the past five years. However, it spits out a ton of income, which makes its after-tax returns much worse. Deutsche Quantitative Equity (DBQIX) is a newer model worth a look, too. This fund buys S&P derivatives and then makes merger arbitrage plays in order to surpass the index. So far, it's well ahead of the S&P 500.

Real estate funds: These funds make nifty diversifiers, but real estate investment trusts pay big dividends, thus making real estate funds tax-inefficient.

Rapid-fire trading funds: Some quantitatively run funds are run with very high turnover and some even state that they're best held in a tax-sheltered account. N/I Numeric Investors Growth (NISGX) and Bogle Small Cap Growth (BOGLX) are two of the better ones. Fidelity Independence (FDFFX) isn't a quant fund (a fund that uses computer-driven strategies with minimal day-to-day input of the manager), but it is run with tax-sheltered accounts in mind and manager Fergus Shiel has done nice work since taking over in 1996.

Who cares about one-year tax efficiency? I found one odd bit in the SEC's new requirements for after-tax disclosure. The SEC is requiring fund companies to disclose a fund's one-year returns on an aftertax basis in addition to longer time periods. I have no idea why this would matter. If you are holding a fund for only a year, clearly you don't care about tax efficiency and you're going to pay taxes on all the gains you made that same year anyway.

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