Tax-Efficient
Mutual Funds: Investors' Salvation
or Much Ado
About Nothing?
Tax-Efficient
Mutual Funds: Investors' Salvation
or Much Ado
About Nothing?
by Nadalyn C. Larsen
Most
people have found some truth in the adage that the only certain things in
life are death and taxes. Likewise, it seems that most people spend their
lives avoiding both. Why then are tax efficient mutual funds the market's
best kept secret?
Mutual
funds have long been viewed as a relatively safe and efficient way for investors
in all tax brackets to have their investments distributed across a variety
of investment options. The investor's anticipation is that their money will
not only be invested wisely but frugally. At the end of each year investors
eagerly examine their returns. Tax efficiency isn't their greatest concern
until they are grinding their teeth over the hit they take on capital gains
at tax time.
Joel
Dickson, an analyst at the Vanguard funds, one of the few families offering
funds specifically aimed at tax efficiency, and John Shoven, a Stanford
economist note the IRS takes an average of nearly two percent annually from
the average fund investor's return. Dickson theorized that investors could
save 50% in taxes if fund managers concentrated on limiting the taxable
gains from funds distributions.
The
Taxpayer Relief Act of 1997, though it reduced the long-term capital gains
tax rate on securities held longer than 18 months from 28 percent to 20
percent, it did not reduce rates on a fund's dividend income or short-term
gains (less than 12 months), which remained taxed at standard income rates
(as high as 39.6%). Intermediate-term (12 to 18 months) gains can be taxed
at rates as high as 28 percent. Dick Bellmer of Deerfield Financial Advisors
in Indianapolis warns that this category could harbor the biggest tax danger
since many funds garner such gains due to their trading practices. Receiving
maximum benefit from the act are investments held five years or longer.
These will be taxed at eight percent for taxpayers in the 15 percent tax
bracket and 18 percent for all other taxpayers.
The
solution would appear to be the relatively new "tax efficient managed
funds." This alternative seems especially attractive in light of this
year's bull market. As opposed to the traditional mutual funds, with the
exception of money market and tax-exempt funds, which aim to maximize before-tax
return; tax-efficient or tax-managed funds maximize after-tax returns through
long-term portfolio investments.
Tax-efficient
funds base their growth in large part on capital appreciation instead of
growth and income. Funds try to enhance tax efficiency through a variety
of strategies. A fund may hold its investments for the 18 months or longer
before selling - maintaining a low turnover rate and reducing capital gains
distributions. They may invest in index-oriented stocks to reduce taxable
distributions. Similarly, some seek out low-yielding stocks. When selling
securities, some funds first sell off the highest cost groups to minimize
capital gains or sell particular securities that will produce a loss, thereby
offsetting potential capital gains, a practice called "tax loss harvesting."
Another method of evading producing taxable income is to avoid buying stocks
of those companies that pay high dividends.
The
Vanguard Group, which offers three tax-efficiency focused options, recommends
these funds to investors not only interested in long-term growth of capital
with low immediate taxable income, but who are also looking toward "a
long-term investment horizon (at least five years)." The company advises
against these particular funds for investors "unwilling to accept significant
fluctuations in share price, investors seeking significant dividend income,
and those seeking to beat the market return on large-capitalization stocks,
which dominate the S&P 500 Index."
There
are additional criteria to consider. Most tax-managed funds require a considerable
initial investment, $10,000 to $1,000,000. Some funds with the high-end
initial investments are open only to institutional investors. It is estimated
that over 40 percent of American family units have stock investments. Only
a small percentage of these would fall into the category able to manage
such numbers. T. Rowe Price began offering a Tax-Efficient Balance Fund
in June 1997 with a required initial investment of $2,500. Delaware -- Voyager
(load funds) recently began offering two options with initial investments
of $1,000.
Should
investors opt to switch to tax-efficient funds, they need to keep in mind
a variety of factors. Potential investors may be advised to examine the
tax efficiency rating, the ratio between their pre-tax and after-tax returns,
of prospective funds. Secondly, exchanging from one fund to another is taxable
unless shares are in tax-deferred investments. Bellmer advises caution in
timing purchase of funds, "...you do not want to purchase a new fund
just before it is set to pay out a substantial distribution (or even a small
one). The reason for this is that although the value of your actual holdings
in the fund will remain the same, you will be forced to pay taxes on gains
that you have not been around to enjoy."
Timothy
Middleton, Worth Online, says to keep tax efficiency in the proper
perspective when selecting a mutual fund. He recommends that investors keep
in mind three basic characteristics of mutual funds: First, "mutual
funds create annual tax liabilities for shareholders, even if they never
sell a share," because fund owners pay taxes on capital gains when
they sell shares and on dividends and capital gains from sales and acquisitions
of stocks for the fund's own portfolio. "Second, funds that do a lot
of trading tend to generate more capital gains to be distributed to investors
and taxed annually. Third, some managers pay more attention than others
to using losses to cancel out taxable gains."
Maria
Atanasov, in the February 2, 1998, issue of Fortune echoed Middleton's
advice to exercise caution before going after what she refers to as "the
latest Holy Grail." She advises that "pursuing tax efficiency
for its own sake is pointless. Why not simply stick with funds that were
efficient in the past? Because a fund that achieved efficiency by letting
its gains accumulate may simply have turned itself into a ticking tax bomb.
It will have to sell its winners eventually, and the distribution could
be huge." Atanasov cites research done by Susan Belden of the No-Load
Fund Analyst newsletter. After studying fund turnover compared to tax-efficiency
over three- and ten- year periods, Belden concluded that turnover and tax
efficiency were not related. Atanasov advises investors to divide their
portfolio between funds gaining their primary returns from income, such
as IRA's and 401(k)'s or other tax sheltered vehicles, and taxable funds
focused primarily on long-term gains.
Why
are tax efficient mutual funds the market's best kept secret? Individual
investor's goals do not normally coincide with tax-efficient fund objectives
of long-term investment and limiting income. Additionally, most individual
investors are not willing to meet the minimum investment criteria of the
majority of the currently available tax-efficient mutual funds. Finally,
investment advisors promote the belief that the goal of tax reduction can
be achieved by other investment strategies. The moral to this story is,
as one must sometimes make decisions about the quality of oneís life,
so it is with investments and taxes. One must weigh potential tax savings
against investment goals and hope they choose wisely.
Editor's Note: Nadalyn C. Larsen is a freelance writer for Trade Press
Services. In addition to her writing, her professional career includes teaching,
training and fund raising activities.
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