New Alternative Funds are Tax-Friendly

How do you get around the hassle of annual mutual fund capital-gains distributions?

One alternative is to invest in index funds, which generally are tax-efficient because the funds try to simply buy and hold, rather than trade.

So-called tax-managed funds, which seek to minimize distributions, also are increasing in number. (More on these later.)

One of the newer alternatives to traditional mutual funds, however, is the exchange-traded fund, or ETF.

Although the ETF concept has been around since 1993, its popularity has exploded. There are about 100 trading on the American Stock Exchange.

ETFs have evolved from ‘Spiders,’ or Standard & Poor’s 500 depositary receipts, to a host of vehicles tracking all sorts of broad indexes and narrow industry-sector indexes.

ETFs are bought and sold like regular stocks. A major element of their appeal is that they are supposed to be structured to avoid having to pay out much in capital gains--though this has yet to be proven.

Though ETFs are index products, actively managed ETFs could be around the corner. Amex executive Lawrence G. Larkin recently called them ‘the natural progression in the industry.’

Another product seen as a threat to the traditional fund is the so-called synthetic fund. Synthetics allow investors to trade pre-selected or individualized baskets of stocks with much more portfolio visibility and tax control than traditional funds offer, usually for a monthly or annual subscription fee.

Synthetic funds become a cheaper alternative to regular mutual funds for portfolios worth $20,000 to $30,000 or more, according to analysts at Morningstar Inc. and at Maxfunds.com. For investors with smaller portfolios, traditional funds with reasonable fees are more cost-effective.

For investors who want to stick with traditional funds, index funds and funds that pitch themselves as being tax-managed can be your best bet if you want to limit your capital gains distributions. But beware: Even these funds aren’t bulletproof.

A few so-called tax-sensitive mutual funds may need to dole out distributions some years.

Though index funds that track the blue-chip S&P 500 are generally reliable for their tax-efficiency, funds that track indexes that have more turnover among their member stocks are more vulnerable to generating distributions.