These funds can help boost returns for taxable accounts

Municipal bonds can help, as can built-in losses

Dollars & Sense

November 02, 2003|By Russel Kinnel | Russel Kinnel,MORNINGSTAR.COM

If you're choosing investments for a taxable account, one of the easiest ways to boost your returns is to factor taxes into your selections.

Today, I'll outline ways to find funds that should provide pleasing after-tax returns for many years to come.

Consider a tax-managed fund.

I'm always surprised when reporters ask me whether tax-managed funds are gimmicks. Taxes are very real, and so is their effect on fund investors' returns.

Most stock-fund managers pay little heed to taxes, so making an effort to invest with one who does is likely to pay off.

Tax-managed funds have consistently put up above-average after-tax returns. These funds' most important tactic is realizing losses to offset gains so as to minimize capital gains distributions.

Some funds are passive, index-like vehicles that have the advantage of having low turnover and holding a wide array of stocks, which improves the odds of having tax losses to harvest. Others are active funds, which are more likely to make the occasional distribution but should still deliver decent after-tax returns.

One of the best passive examples is Vanguard Tax-Managed Growth & Income (VTGIX). The fund hasn't made a capital gains distribution since it was launched in 1994, and its five-year annualized after-tax returns are in the large-blend category's top third.

On the active side is Oakmark Fund (OAKMX), which Bill Nygren runs in a rather bold value style. It will make an occasional distribution, but Nygren keeps taxes in mind, and the fund still has some tax-loss carry-forwards that should put it in good stead if the current rally has legs.

Buy a municipal-bond fund.

If you're in the top tax bracket, a muni fund might be a better option for you. You can test that assumption with our bond calculator, which can help you determine if you're better off investing in taxable or municipal bonds using a tax-equivalent yield function.

Buying a muni fund is a little different from buying a taxable fund. Munis are less liquid and less researched than taxable bonds, so you should look for a fund that's nicely diversified and doesn't take on a lot of credit risk.

A couple of weeks ago, I had a chance to visit Fidelity's muni group in New Hampshire and came away impressed. Fidelity's strengths have always been investment technology and issue-selection, and its muni group has done a great job of harnessing both. Fidelity Spartan Intermediate Municipal Income (FLTMX) is proof of how well that strategy has worked.

Look for a fund with a built-in tax loss.

If a fund has losses on the books, its shareholders will enjoy a free ride until it works those losses off the books or those losses expire.

Scores of growth funds have big losses from the bear market even after this year's rally. It's harder to find a good small-cap fund with a built-in loss, however.

One of the few is FPA Paramount (FPRAX), which has a big loss built up by previous management. Current managers Eric Ende and Steve Geist have built a strong record at another FPA fund, and we're optimistic they can repeat their success here.

Get dividend exposure in a moderate-allocation fund.

Because of a quirk in tax codes, you can get better after-tax returns when a dividend-focused portfolio is wedded to a bond portfolio than you would from buying each portfolio separately.

The reason is that funds pay their expenses with yield, and they get to designate which sources are paying the expense ratio and which should be distributed to shareholders. Thus, a balanced fund can send all its stock-dividend income, which is taxed at a lower rate than bond dividends, to shareholders and use bond income to pay off expenses.

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