Tax-managed funds back in the spotlight

Nov 11, 2012 @ 12:01 am

By Jason Kephart

The likelihood of higher taxes is making tax-managed mutual funds more popular.

With President Barack Obama's re-election, the capital gains tax could jump to 23.8%, from 15%, and the tax on dividends could skyrocket to 43.4%, from 15%, for high-income taxpayers next year if the Bush-era tax cuts are allowed to expire.

For clients in taxable accounts, those higher rates could cause a lot of headaches. One tool that financial advisers have to lessen the tax burden of owning equities in such an account is the tax-managed mutual fund.

“I've got to do what's best for clients, and they don't like to pay taxes,” said Laura Scharr-Bykowsky, principal at Ascend Financial Planning LLC.

She has ramped up the use of tax-managed funds in her clients' accounts because she expects hi- gher tax rates next year.

Ms. Scharr-Bykowsky has even been selling some well-performing mutual funds to lock in returns at today's capital gains rate and replacing them with tax-managed funds.

Tax-managed funds, which have about $53 billion in assets, up from $40 billion three years ago, are designed to maximize after-tax returns.

In general, most mutual funds are focused on earning the highest pretax return, which can lead to capital gains distributions.

To lower the risk of unwanted capital gains, tax-managed funds use a few old investment tricks.

“It's not rocket science,” said Duncan Richardson, chief equity investment officer at Eaton Vance Corp. “We're using sound long-term investing techniques.”

Tax-managed funds generally keep turnover low, while aggressively selling poor-performing stocks to lock in losses that can offset future gains. They also shy away from dividend-paying stocks, something that could be even more dramatic if the dividend tax rate increases.


“It's something we're keeping an eye on,” said Jed Fogdall, co-head of portfolio management at Dimensional Fund Advisors, the second-largest provider of tax-managed mutual funds, behind The Vanguard Group Inc.

Whether a mutual fund is managed in the most tax-efficient way probably isn't clients' primary concern, but the capital gains tax rate is.

“Clients hate paying taxes on a gain,” said Hilary Martin, a financial adviser at The Family Wealth Consulting Group. “It's completely disproportionate to how they feel about positive returns.”


Tax-managed funds have been largely overlooked over the past few years because there just haven't been many capital gains to worry about, said Tom Roseen, senior research analyst at Lipper Inc.

But that could be about to change.

Mutual funds distributed $73 billion in capital gains in 2011, well below the peak of $414 billion distributed in 2007. One reason that distributions have been so low is that mutual funds have been using the losses from the financial crisis to offset gains from the stock market's rebound.

That, however, won't last forever.

“We're setting ourselves up for what could be a double whammy,” Mr. Roseen said. “Really good returns and a big tax drag because all the tax loss carry-forwards have been used up.”

In fact, while the $73 billion distributed last year is relatively low, the numbers have been rising since reaching a low of $16 billion in 2009. In 2010, funds distributed $43 billion in capital gains.

Because of flat equity returns over the past 10 years, there hasn't been much difference in performance between tax-managed funds and the rest of the fund universe.

For example, a $10,000 investment 10 years ago in the $11 billion Vanguard Tax-Managed International Fund (VTMGX), the largest tax-managed fund, would be worth $10,420 today, versus $10,214 in the non-tax-managed Vanguard International Stock Fund.

But if capital gains increase, the after-tax returns could look a lot different.

Studies in the 1990s, when capital gains were much more prominent, found that investors were losing 2% to 3% a year due to taxes, which is double or even triple typical expense ratios, Mr. Roseen said. Twitter: @jasonkephart


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