Some investors in mutual-fund shares are getting a shock these days. As they work out their federal and state taxes for the April 15 deadline, they find they owe Uncle Sam big bucks on the earnings of those shares.
Not all mutual-fund shareholders have that problem. About two-thirds of the 93 million mutual-fund shareholders in the US have money in tax-deferred accounts such as Individual Retirement Accounts and 401(k) or 403(b) plans. They do not pay taxes on income or capital gains incurred by their investments until the money is withdrawn at retirement or otherwise.
But 69 percent of shareholders have some mutual-fund assets outside of qualified plans and are subject to taxes in the billions, according to the Investment Company Institute.
Still, a minority of the latter group have invested in "tax-managed" funds that consciously strive to limit the tax bite with their investment strategy.
These funds "eliminate one of the biggest drags on mutual-fund performance: turning too much of their returns over to the United States government," says Duncan Richardson, portfolio manager of the $19 billion Eaton Vance Tax-Managed Growth Portfolio. They also "enable shareholders to regain control of their taxes," he says.
Since February, the Securities and Exchange Commission has required every mutual fund to include in its prospectus a table giving after-tax performance for 1-, 5-, and 10-year periods, as well as its pretax returns. That promises to give tax-managed funds a boost as investors see more clearly the size of Washington's tax take. It could "easily" take 1 or 2 percent a year off a mutual fund's performance, reckons John Shoven, an economist at Stanford University in Palo Alto, Calif. For long-term investors, that could compound up to 20 or 30 percent over 10 to 15 years.
While many fund investors know that management fees and sales fees shrink the return on their shares, fewer think about the largest cost of all taxes.
Mutual funds must, by law, distribute at least 90 percent of their income and capital gains to shareholders. Even though shareholders may decide to have that money automatically reinvested in more shares, they still owe taxes on it.
With tax-managed funds, usually only a few percent or less of the return is subject to taxes.
The big question for investors: Do tax-managed funds have lower pretax returns than other similarly managed funds, so that the tax advantage is more than offset by a lower return?
That's not likely, says Professor Shoven. "Investors give up little if anything on before-tax performance and save on after-tax performance," he says.
Any fair comparison of the average performance of tax-managed funds with others would be tricky statistically. Experts know of no such study.
But Morningstar, a Chicago-based mutual-fund-tracking firm, recently published a list of tax-managed funds with after-tax returns that beat the average pretax return of the typical fund in their respective categories over the five-year period ended Feb. 28. Shareholders in these funds didn't sacrifice performance for the sake of tax sensitivity. "Most investors will get some benefit from using tax-managed funds," says Morningstar analyst Peter Di Teresa.
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.