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."