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.

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