Tax-sensitive funds are gaining new interest from investors.
A flurry of capital gains distributions in 2005 and
the recent extension of favorable tax treatment for stock dividends
have given funds that distinguish themselves through tax sensitivity a
second wind.
For most of the past decade the quirky nature of
mutual taxation has received little attention from investors. In the
late 1990s few people seemed to care about short- or long-term capital
gains distributions, at a time when equity funds were generating
bountiful double-digit returns. For a brief period in 2000, the issue
of fund taxes grabbed headlines as investors concurrently weathered a
plunging stock market and mammoth capital gains distributions of more
than $324 billion. There was a silver lining in the devastation,
though. By 2001 many equity funds had banked substantial capital losses
that they could use to offset gains for years to come. Funds that were
once tax magnates suddenly, and often inadvertently, became
tax-efficient.
That changed last year, when many of the funds ran
out of tax loss carry-forwards and were forced to distribute capital
gains to shareholders. According to a well-publicized Lipper Research
study titled Taxes in the Mutual Fund Industry-2006, total short-term
capital gains increased 57%% over 2004 levels, while total
distributions from equity funds jumped 94%. Between 2001 and 2005 the
average "tax drag" on returns for U.S. Diversified Equity Funds was
just 0.48%. Last year, it crept up to 88 basis points.
While taxes have taken a smaller bite out of returns
than expense ratios over the last few years, that could change soon,
says Tom Roseen, senior research analyst at Lipper's Denver office.
"Even with the favorable tax rates for qualified dividends and capital
gains, most equity mutual funds will not be tax-efficient in the
future," he says. "The impact of taxes could easily be double or triple
the impact of expense ratios again."
Investors seem to be waking up to the issue.
According to a survey by Eaton Vance, which offers nine tax-managed
funds, a growing number of investors (44%, compared to 27% in 2001)
said they have invested specifically with consideration to after-tax
returns or tax efficiency.
But fund offerings do not appear to be capitalizing
on those concerns. At the end of last year tax-managed funds held $44.4
billion in assets, up from $30 billion in 2000 but still only about 1%
of assets in taxable accounts. Roseen says part of the reason may be
that fund companies don't place a high priority on tax efficiency.
"Portfolio manager compensation is based on total return, not after-tax
performance, and retirement accounts are an important part of many fund
families," he observes. "Total returns are what drives fund inflows."
Tax-managed funds face challenges on other fronts.
Tax efficiency is not a high priority for many people, including
investors who have trillions of dollars in IRAs, 401(k) plans and other
tax-deferred accounts. A losing year for the stock market could once
again shower funds with losses they can use to offset gains, making
many stock funds tax-managed by default. Two bills in Congress that
would allow investors to defer taxation of reinvested capital gains in
taxable mutual fund accounts until redemption would make tax
sensitivity in mutual funds an archaic notion.
Roseen notes that similar reforms have been
discussed for years, and that recent tax cuts and a growing deficit
work against their passage. Barring a brutal bear market, he says,
higher tax bills appear likely for the estimated 46% of mutual fund
assets in taxable accounts. "At a time when expectations are for more
normalized returns in the 8% to 10% range, sacrificing two to three
percentage points to taxes is no small matter," says Roseen. "I think
people are going to be revisiting this issue, and that interest in
tax-managed funds will grow."
That's probably good news for companies such as
Vanguard, Eaton Vance, Fidelity and other fund complexes that have
built a stable of tax-friendly funds whose mission is to differentiate
themselves on the basis of after-tax returns. Investor interest in
tax-managed offerings waned between 2001 and 2004 but has picked up
more recently, says Duncan Richardson, executive vice president and
chief equity investment officer at Eaton Vance. "A lot of people who
entered the profession over the last five years haven't focused on
taxes because they got a tax holiday courtesy of the bear market," he
says. "We're trying to educate a new crop of people about the issue."
Richardson's firm was the first company to offer a
tax-managed fund, in 1966. According to Lipper, 35 fund families
offering 23 different fund classifications have followed suit. There
were 192 tax-managed funds from various share classes at the end of
last year, up from 42 in 1997. These did not include index funds or
ETFs, which are supposed to be inherently tax-efficient, or funds that
are managed in a tax-effective manner but promote it as a footnote.
Firm founders whose names are on their funds often fall into the latter
group because they have much of their personal taxable wealth invested
in their funds.
Traditionally, tax-managed funds have relied on
buy-and-hold and loss harvesting strategies to minimize capital gains.
The new generation of funds that call themselves tax-managed gear their
strategies to income seekers who want to capitalize on the 15% tax rate
on qualified dividends that was recently extended to 2010. They may
invest in dividend-paying stocks, engage in covered call writing and/or
balance their portfolios with high-yielding stocks and municipal bonds.
Even in low-expense funds, a plain vanilla strategy
of investing in dividend-paying stocks rarely produces yields of more
than 3%. To help beef up payouts, some of the newer offerings, such as
the Goldman Sachs U.S. Equity Dividend and Premium Equity, also engage
in covered call writing using index options. For tax reasons, the
option income is held back and paid out at the end of the year, while
dividends are distributed on a regular basis. Goldman Sachs managing
director Donald Mulvihill says the fund "answers the need for retirees
to generate some cash for living expenses and still maintain the value
of the portfolio after inflation."
That fund has attracted $115 million in assets since
its inception in August 2005. The Goldman Sachs CORE Tax Managed Fund,
which is managed to avoid capital gains, is targeted at "investors who
are unlikely to outlive their assets and wish to pass along as much as
possible to family members or charities." The fund has never paid out
short- or long-term capital gains in its six-year history.
Challenges Ahead
Tax-managed funds face competition from index funds
and exchange-traded funds, which are each considered very tax-efficient
and are popular among passive investors. For those who want active
management, a number of fund families, such as Oakmark or Bridgeway,
have long-term, buy-and-hold investment strategies that lend themselves
to tax efficiency but don't necessarily promote that feature.
Separately managed accounts, which have come to the
forefront in recent years, give investors more control over the timing
of taxes. But Richardson says they aren't the panacea many people had
hoped for. "From my observation, it seems that advisors do not always
carry through on customized recommendations," he says. "It takes a lot
of extra effort to implement tax-managed strategies over a large number
of accounts. Theoretically there is an opportunity to harvest tax
losses, but I'm not sure that happens in practice."
He also believes that while some funds may be
tax-efficient by nature, the tax policies of those specifically labeled
as tax-managed are more predictable. "Things could change drastically
if a portfolio manager leaves," he says. "Tax efficiency in the past is
not a good proxy for what goes on in the future."
Despite the threat of higher capital gains
distributions and increasing tax awareness, some advisors haven't
warmed up to the idea of investing in tax-managed funds.
"We have invested in tax-managed funds, but found
the regular version of the same funds have done better even on an
after-tax basis," says Michael Anderson, an advisor with Evensky &
Katz in Coral Gables, Fla. "Tax efficiency is not a leading reason for
us to choose a fund. And we won't necessarily sell just because a big
capital gains distribution is coming up." Instead, the firm manages tax
liabilities by taking steps such as avoiding purchases just before a
distribution or offsetting capital gains with losses.
Penny Marlin, president of Marlin Financial Services
in Delray, Fla., prefers funds that have low portfolio turnover but
does not necessarily seek out those that are specifically tax-managed.
"It's not something that's on the front burner, for sure," she says.
"But I am taking a look at some high-dividend funds, particularly after
the extension of the Tax Act. That's a promising area, from a tax
perspective."
Of course, not all tax-managed funds are created
equal. Some are just poorly managed. They will not always have better
returns on an after-tax basis than their category peers. And at times
when many equity funds have large loss carry-forwards their tax
efficiency may not be that impressive by comparison.
Still, Richardson argues that tax efficiency is a
"dead certain way to add value. You can spend a lot of time trying to
find a manager who may or may not outperform the market. Or you can use
a more predictable alternative by adding 200 basis points to after-tax
returns with a well-run fund that is managed to control taxes."