This fund manager says tax efficiency should be a policy, not an accident.

What do you do if you manage a tax-sensitive mutual fund that usually bypasses stocks with high dividends, but you want the stability and bear market resilience those same stocks offer?

Christopher Luck, co-manager with Robert Arnott of First Quadrant Tax-Managed Equity Fund, tries to figure out whether the likelihood of incremental returns outweighs the drawback of added taxes. "Normally, we tend to avoid dividend-paying stocks, all things being equal, so we don't have an ordinary income distribution," says Luck. "However, in this environment, things are clearly not equal with respect to dividends. With increased market volatility and with earnings struggles across the market, our models strongly prefer the safety of dividends. The return potential in these stocks generally outweighs the tax cost associated with them."

Luck thinks that's the case for the 13% of the fund's assets that are in high-yielding real estate investment trusts, or REITs, up from 5% a year ago. He points out that not all REIT yields are created equal, and that one-third to one-half of the dividend yield of some REITs is actually a non-taxable return of capital. To find those, he looks for stocks with a historical pattern of including a generous return of capital in their dividend mix, such as Vornado Realty Trust.

The fund's weighted-average dividend yield, which increased from 1.1% at the beginning of 2002 to 2.3% by the end of the third quarter, reflects the shift. Although that yield is just a shade higher than the 2% dividend yield of stocks in the fund's benchmark, the Russell 3000 Index, it's a sign that Luck thinks that in some cases, the tax tradeoff is worth having a safety net.

To determine whether that tradeoff makes sense for a particular stock, Luck applies what he calls a "tax penalty function." If a stock has a 5% dividend yield, for example, the tax penalty for someone with a marginal income tax rate of 38.6% is roughly 2%. So the question becomes whether Luck believes such a stock will appreciate at least 2% more than the overall market and thus overcome the tax burden that accompanies the dividend.

Beating The Benchmark

Taming the tax side of dividend income is one strategy Luck employs to help the fund live up to its tax-efficient name. He also uses other tax management techniques, such as a buy-and-hold strategy that avoids realizing short-term capital gains, deferring realization of long-term capital gains and realizing losses to offset realized gains.

Although this is Luck's first stab at running a mutual fund, Pasadena-based First Quadrant, where Luck is a partner and director of equity portfolio management, manages some $15 billion in assets for institutional and high-net-worth clients. About $500 million of that is in taxable, separately managed accounts.

To construct the fund's portfolio, Luck uses a top-down market and economic analysis to decide which sectors and industries are likely to excel. Industry weightings typically do not differ from those of the fund's benchmark, the Russell 3000, by more than 5%. He selects individual stocks based on a bottom-up analysis of valuation, earnings revisions, insider trading, and merger and takeover activity.

Luck and Arnott's recent emphasis on stocks with below-market volatility and a history of stable earnings has helped keep the fund in the forefront of its peer group. Its shares declined 7.4 % in 2001, its first full year of operation, compared with a drop of 11.9% for the S&P 500 and 12.2% for its Morningstar large-blend category average. As of November 1, it was down 18% for 2002, placing its performance in the top 21% for its Morningstar category. Such are the yardsticks of success these days.

The fund's largest holding, Annaly Mortgage Management, typifies a defensive, bear-market-defying stock that has benefited from falling interest rates. The commercial mortgage REIT has a yield of about 14% and a history of increasing dividends, yet sells at just over eight times earnings. The stock is up 21.4% this year as of November 1.

Stocks involved in takeover activity also have fared well. Pharmacia rose 11% in the third quarter on its takeover by Pfizer and is up 10% this year as of November 1. American Water Works, another takeover play, is up 9% for the year. Several recently established positions represent special situations that should benefit from merger activity or corporate actions. These include NCS Healthcare, involved in a hostile takeover situation, and Hollywood Casino, the subject of a friendly takeover.

At 27% of assets, financial services represents the fund's largest sector weighting. Although low interest rates still make the group attractive, Luck has been trimming his positions in large money-center banks, such as Citigroup, because of increasing corporate loan losses and moving toward banks with a tamer lending profile, such as Bank of America and Wells Fargo.

Companies in the consumer discretionary category, such as those in the automobile, hotel and media industries, account for nearly one-quarter of fund assets-substantially higher than the 14% allocation for the benchmark. Luck says that despite concerns about the economy and market turmoil, the group remains attractive because consumer spending has showed surprising strength even in a weak economy. Among automakers, he prefers General Motors because of its growing earnings and strong franchise, but remains wary of Ford's declining market share and restructuring problems.

In the beaten-down growth-stock category, Luck continues to accumulate Walt Disney, which he began buying in early 2002. Although the stock has drifted downward since then because of declining revenues, he thinks the company's strong franchise and opportunities for earnings recovery make Disney "extraordinarily cheap."

Luck's interest in fallen angels like Walt Disney reflects his desire to add more reasonably-priced growth stocks to the fund mix going forward. "Value stocks are no longer a slam-dunk anymore," he says. "On a selective basis, some great growth companies have become fairly valued, if not undervalued."

SIDE BAR

Is Taming Taxes Still A Valid Strategy?

When First Quadrant Tax-Managed Equity Fund was launched in December 2000, investors were simultaneously reeling from a sudden market downturn and a year of record mutual fund capital gains distributions. "We felt there was a strong need for a solid tax-managed mutual fund offering," says Luck. "The taxable investor was not being served well by most existing actively managed funds."

Today, as prolonged market losses have created a virtual capital gains distribution drought, the argument for tax-managed investing often falls on indifferent ears. Yet Luck believes that there is still a place for tax-managed funds in taxable accounts. "Ultimately, the market will recover," he says. "So while fund taxes aren't an issue now, they almost certainly will be in the future. Investors want to be in a mutual fund where tax efficiency is a policy, not an accidental byproduct of a bad market."

The fund's co-manager Robert Arnott, First Quadrant's managing partner and chief executive officer, played a large role in crafting that policy. In 1993, a widely publicized article in the Journal of Portfolio Management that he co-authored concluded that only a small minority of actively managed mutual funds beat the performance of the S&P 500 Index on an after-tax basis. His more recent studies, published in 2000 and 2001, reached similar conclusions.

With assets standing at just $8 million for the nearly two-year-old fund, the challenge now is getting that message out to the public. To help keep the tab for such a small offering in check, net annual fund operating expenses borne by shareholders are capped at 1% through March 1, 2003. While there are no immediate plans to extend the cap, Peter Lebovitz, president and CEO of The Managers Funds (which sponsors First Quadrant Tax-Managed Equity) says he "would be surprised" if the fund's board of directors does not grant such an extension.