NOBODY LIKES TO
write Uncle Sam a big check. That's why mutual-fund investors not only have to worry about low fees and poor performance but also a hidden aspect of their portfolio that can wind up being just as costly: capital-gains taxes.
Mutual funds are required to pass along profits in their portfolios to shareholders in the form of a capital-gains distribution, either at the end of a quarter, every six months or at the end of the year. (Your fund's annual report will outline the timing.) These payouts are taxed at standard capital-gains rates, so the trick for every manager has always been to balance the profits from selling winning stocks with offsetting losses of those that tanked. That way the average investor doesn't get hit with a large tax bill. (Of course, if you're investing in a tax-advantaged account like a company savings plan or an individual retirement account none of this will affect your standing.)
But even shareholders who invested in a brokerage account, for example, have been able to forget about capital gains the last few years. That's changing quickly. Mutual funds are allowed to stockpile losses and carry them forward to the next year. Earlier this decade, a bear market enabled many managers to do just that. According to Lipper the average mutual fund paid out between 16 cents and 17 cents a share in 2002 and 2003. Since then, the stock market has gone on a roll (not including the last month, mind you), which means all the bear-market losses have pretty much dried up. Indeed, the average capital-gains distribution, according to Lipper, skyrocketed to $1.09 a share in 2006. "After expenses, taxes are the single-biggest detriment to a fund's returns," says Jim Hiles, a financial planner with wealth manager CBIZ.
Don't worry, though. There are top-performing funds that are low-cost in addition to being tax-friendly. For this week's SmartMoney fund screen, we used Lipper's tax-efficiency rating system. This tool allows us to measure how much of a fund's gains are left after Uncle Sam takes his cut. A "1" score means a fund was in the top 20% of its peer group when it came to keeping as much profits as possible. We limited our list to funds with a "2" or better. One caveat: The scores are derived by comparing funds in different classifications. Some fund categories are more tax efficient than others so the impact of a "2" can vary greatly depending on which group you are looking at. "Just because your fund says it's 'tax managed' doesn't make it a better fund," says Hiles. "Some of this is about marketing and [investors] need to be aware of that." Hiles doesn't like to invest in a fund that lost more than 1% of its annual gains to taxes. (If you use Morningstar to do your homework, that site has similar tools, including one that tries to anticipate a fund's payout.)
Tax efficiency and good returns can be a potent combination, so we demanded that this week's winners also have top-tier performance track records. Turnover was a big consideration, too. A manager that rapidly trades his portfolio, say 100% or 200% turnover a year, can easily trigger capital gains. That's too high for our taste.
Regular readers of this column will be familiar with many of the 37 funds that made our cut; they have appeared on several of our screens in the recent past. Excelsior Value & Restructuring favors companies that are overhauling their operations. It hasn't paid out any capital gains over the last six years. James Equity uses around 200 financial criteria to pick stocks it thinks will rise in price over the next several years. It paid out a measly $41,000 last year thanks to a $1.8 million loss carry forward. Dodge & Cox International is one of the best foreign funds on the market. This $36 billion offering has an average annual return of 19.3% over the last five years, putting it in the top 12% of its peer group. The managers chalked up that performance with just a 9% turnover rate. In other words, they picked their winners and stuck by them.
There are a few funds on the list, though, that you may not know well. FBR Small Cap, run by Chuck Akre, had been closed since 2004 before it reopened earlier this year. Akre looks for companies that have at least a 20% return on equity, a measure of how well a firm is employing its assets. "There is a lot of accounting garbage out there so we just get rid of it," says Akre. He thinks ROE is the best predictor of a decent long-term investment. According to Lipper, this fund is tops in its group over the one-, three- and five-year time periods. Amana Income fund is a religiously-themed mutual fund geared toward Muslim investors. It doesn't invest in companies that violate strict screens. (To read more about this fund click here Over the last three years it has returned an average annual 18.9%, nine percentage points better than the S&P 500. Those numbers should sound good to any investor, regardless of whom they pray to at night.
With help from the Lipper database we looked for funds that had a tax efficiency rating of "1" or "2". In addition, the funds had to have average annual returns over the three- and five-year time periods that put them in the top 30% of their peer groups. As usual, the funds also had to be open to new money, require less than a $5,000 minimum and charge less than a 1.5% expense ratio. Load funds were cut from consideration.
Data as of March 15, 2007
The Tax Efficient Fund Screen Recipe
Fund Classification = All
Annualized 3-Year Return (%) = Display Only
Rank in Classification (%) (3 year performance) <= 30
Annualized 5-Year Return (%) = Display Only
Rank in Classification (%) (5 year performance) <= 30
Expense Ratio <= 1.5%
Load Fund (type) = No Load
Investment <= 5,000
Open to New Investors = Yes
Total Net Assets ($ millions) >=1
1-Year Return (%) = Display Only
Rank in Classification (%) (1 year performance) = n/a
Annualized 10-Year Return (%) = n/a
Rank in Classification (%) (10 year performance) = n/a
Fund Type = n/a Return-Since-Inception (%) = n/a
Year-to-Date Return (%) = n/a
3-Month Return (%) = n/a Manager's Tenure = n/a
Trailing 12 mo. Yield = n/a
Tax Efficiency Rating <= 2
Turnover <= 50