Cautious investors look at tax-managed funds

Reality: After the collapse of Internet stocks, mutual funds that minimize the IRS' bite are popular and needed.

Dollars & Sense

October 28, 2001|By Paul Adams | Paul Adams,SUN STAFF

A year ago, many investors shunned sober-sounding tax-managed mutual funds in favor of ones that focused on high-flying Internet stocks.

But recent months have seen tech stocks tumble, making many investors rethink their strategy.

Investors who enjoyed eye-popping returns of 20 percent or more in the late 1990s have been dealt a bitter dose of reality, with many seeing the value of their holdings plunge at the same time that capital gain distributions and dividends was jacking up their tax bill.

As a result, interest in funds that are structured to minimize taxes without sacrificing returns has increased. The sell-off in the market spurred by last month's terrorist attacks may have contributed to investor concerns about tax effects.

In 1997, there were just 12 tax-managed funds on the market, according to Morningstar Inc., a Chicago company that tracks the mutual fund industry. Today, there are 63, and about 21 of those were launched in the past year.

"More and more people - especially in the past few years - have been investing outside of their retirement plans, and as a result, they've taken a lot more interest in how good their funds are at protecting them from taxes," said Peter Di Teresa, senior editorial analyst with Morningstar.

Tax-managed funds operate partly on the premise that about 40 percent of the stocks a fund manager picks will turn out to be poor investments. To minimize the capital-gains tax bite, the fund manager tries to offset big gains by selling shares in losing stocks and booking the loss for investors.

As a further measure, tax-managed funds often avoid investing in stocks that pay high dividends, and try to buy and hold stocks for longer periods, reducing the likelihood of having to pay the higher capital-gains tax rate that applies to short-term investments.

"For anyone who is investing outside of a tax-deferred account ... taxes are often the largest cost to shareholders investing in mutual funds," said Joel Dickson, a tax efficiency expert with Vanguard Group. "In fact, over the last 10 years, taxes on distributions have eaten up more than 2.5 percentage points a year in the average equity fund."

Despite their more conservative approach to trading, many tax-managed mutual funds have earned pretax returns comparable to other funds, say fund trackers. When the after-tax advantages are factored in, the return beats funds that are less tax-efficient.

"People, I think, have had the misperception that the only way to get good returns - double-digit returns - is if the money manager is working the money hard," said Don Peters, who manages three tax-managed funds for Baltimore mutual fund company T. Rowe Price Associates.

Peters and other fund experts said the benefits of a tax-managed fund increase with an investor's tax bracket, but even middle-class investors benefit by increasing their after-tax return.

"The demographics of the funds implies that it's the wealthier and perhaps more sophisticated investor that's really picked up on the tax-efficiency category," Peters said. "But I think we're very early in the life cycle of the product. It's something that not all that many people understand and appreciate."

Last year's tax mess jolted people, experts said. Investors have historically been content to pay capital gains taxes when their funds are increasing in value. In that environment, investors are able to cover their tax bill by selling some of their holdings, or offsetting gains with losses.

But as tech stocks began to fall last year, worried investors pulled out of tech-laden funds in high numbers. Fund managers had little choice but to sell holdings in a down market to pay investors.

"Even though technology funds did so badly last year, they had such big gains in previous years that there were not a lot of overall losers to match the gains," said Di Teresa, the Morningstar editorial analyst. "So the funds just sort of turned into tax bombs."

Mutual funds must distribute 90 percent of their net taxable income earned during the year to shareholders. In 2000, mutual funds paid out $325 billion in capital gains distributions, shattering the previous record of $238 billion set in 1999, according to the Investment Company Institute, a Washington-based trade group.

Of that total, $99 billion was taxable, meaning it was paid out to people investing outside a 401(k) or other tax-protected retirement account. That's more than triple the amount of taxable capital gains paid out in 1996 and about 48 percent higher than in 1999.

Investors considering a tax-managed fund should research a variety of funds before writing a check, advisers say.

And beware of older funds, said Geoff Bobroff, a mutual fund industry consultant in East Greenwich, R.I. Portfolio managers tend to sell underperforming stocks and let their best picks appreciate. Eventually, investors could get stuck with the capital gains embedded in mature funds.

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