Promising higher returns by lowering taxes

The number of tax-managed funds has grown from 11 in 1995, with $4.3 billion in assets under management, to 74 now, with $39.3 billion in assets.

A leading mutual-fund group in the tax-advantaged field, Eaton Vance Corp., introduced three new such funds last month – one investing in "mid-cap core" stocks, another in "small-cap value" stocks, and the third emphasizing "equity asset allocation." The latter utilitizes a "fund of funds" approach to invest in the seven Eaton Vance tax-managed portfolios, thereby providing portfolio diversification.

Mr. Richardson holds that taxable shareholders have not gotten "the attention they deserve" from mutual-fund groups. Still, most major fund groups offer a tax-managed fund or funds. The Vanguard group, for example, has five funds with $6.5 billion in assets.

Managers of such funds use several techniques to reduce shareholders' tax liability. They include:

• Holding stocks longer. Richardson aims to hold shares at least five years. More active trading in a portfolio often increases the amount of capital gains subject to taxes. During the market boom of the late 1990s, many aggressive funds turned over their entire portfolios in a year. Earlier, say about 1980, the average turnover would have more likely been about 30 percent.

• Selling poorly performing stocks to offset capital gains realized in other stock sales. Such losses can be carried forward eight years to offset future capital gains.

• Using a common accounting technique called HIFO to reduce taxable income. If a stock has been added to the portfolio over time, the shares bought at the highest price are the first sold (highest in, first out). This reduces the capital gain for tax-sensitive investors.

• Imposing a redemption fee on those selling shares in a tax-advantaged fund. The fee is put back into the fund to offset any capital gains created by the sale that might otherwise hurt the return of remaining investors. Vanguard charges investors in its tax-managed funds such a fee for the first five years.

At Eaton Vance, Richardson uses a conservative approach to investing, aiming for stocks with steady earnings growth of 10 or 15 percent a year, Richardson's fund has had a five-year after-tax annual return of 10.45 percent, better than the comparative average pretax return of 6.87 percent in its fund category.

Last year, though, the fund's shares lost 10 percent in value, less than the 12 or so percent for the stock market as a whole. This year, its shares are up by less than 1 percent.

What will happen to the stock market ahead? "This is a confused market," says Richardson, who served in the US nuclear submarine fleet in the 1980s. "The volatility of the last two years is here to stay."

One lesson of his months in a sub was not to take any "unnecessary risk," he says. But unlike those days he spent under the ocean's surface in relative isolation, Richardson notes, these days he has a flood of information to help him select stocks. He likes that better.

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