Tax-Efficient Funds: There Are Precious Few
If the pain of last week’s tax bill still lingers--and one of your income “problems” was large capital gains payments from your stock mutual funds--maybe it’s time to seek out funds that dislike taxes as much as you do.
The law requires that mutual funds pay out most of their net realized capital gains each year to shareholders. That’s obviously not a problem for investors who own funds in tax-sheltered retirement accounts.
But in a taxable account, it can be a big problem--even pushing some shareholders into higher tax brackets, depending on the size of their short-term capital gains payments.
Long-term gains, meanwhile, now are taxed at a maximum of 20% by Uncle Sam. That was cut from 28% in last year’s tax-reform bill. A 20% marginal tax rate is more favorable than the 39.6% rate on short-term gains, of course--but it’s still a levy that many investors would prefer not to pay if they don’t have to.
Unfortunately, mutual fund investors have no control over their funds’ capital gains payouts. The size of annual payouts depends on how actively a manager trades shares in the portfolio, and how well he or she matches gains with losses.
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For the most part, fund analysts say, mutual fund managers pay little attention to being “tax-efficient”--that is, minimizing annual gains payouts and instead maximizing the long-term growth of the fund’s share price (which puts the investor more in control of tax decisions).
Indeed, a relative handful of stock funds have done a far above-average job of being tax-efficient in the 1990s, according to fund-tracker Morningstar Inc.
Ten such funds are shown in the accompanying chart. All have beaten the return of the average domestic stock fund over the last five years. And all have managed to keep investors’ after-tax returns at 95% or better of the funds’ stated returns.
How is that tax-efficiency figure calculated? Morningstar takes a fund’s stated return, then reduces it for the effect of tax payments that would have to be made on payouts of capital gains and other income.
Five-year tax-efficiency ratings assume that short-term capital gains payments and other short-term income distributions were taxed at a 39.6% federal rate, and that long-term gains payments were taxed at a 28% rate.
State taxes are ignored. If included--especially in high-tax states such as California--a fund’s post-tax return would naturally be lower. (California gives no tax break to capital gains. They are taxed as ordinary income, which means that the state can take as much as 9.3% of your gains if you’re in the top tax bracket.)
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Still, as tax-efficient as the 10 funds shown have been over the last five years, there may be different reasons for that efficiency.
Most--but not all--of these funds have been tax-efficient primarily because of low turnover (i.e., because the fund manager tends to be very buy-and-hold oriented).
The low-turnover funds include Domini Social Equity, Dreyfus Appreciation, Legg Mason Value Trust, MFS Emerging Growth, Muhlenkamp Fund, L. Roy Papp Stock, Schwab 1,000 and White Oak Growth Stock.
Low turnover generally means that less than a third of the portfolio is traded each year. Contrast that with funds that are heavy traders: They may turn over their portfolios completely in the space of a year, or even every six months, depending on market conditions.
A low turnover strategy is what many investors assume accounts for tax efficiency in a fund. But that isn’t always the case.
Russ Kinnel, analyst at Morningstar, notes that a fund that is growing rapidly because new shareholders are pouring money into it also may be tax-efficient without trying very hard. That’s because the new money can effectively dilute the impact of realized gains on stocks.
“Huge cash inflows can make for awesome tax efficiency because it can water down almost all of the fund’s gains” in a given period, Kinnel said.
Two of the funds in our chart--Baron Asset and Kaufmann Fund--have had higher turnover than the others over the last five years, but still have been very tax-efficient, perhaps helped in part by tremendous asset growth.
Kinnel also points out that the turnover figure for a fund can appear artificially low if there has been rapid growth of assets.
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Will these funds continue to be tax-efficient? That’s the challenge, Kinnel noted: There’s no guarantee that a fund that has paid out little in capital gains in the past will also pay out little in the future.
Even fund managers who try to be tax-efficient can be foiled by market conditions--or by their own shareholders.
If a fund suddenly is hit with heavy redemptions by shareholders, the manager may be forced to sell long-term holdings, generating significant capital gains distributions for shareholders who stay invested in the fund.
Kinnel’s favorite funds for investors who want to be in a tax-efficient portfolio are Muhlenkamp Fund and the Schwab 1,000 fund. “They make tax efficiency a part of their strategy,” Kinnel said.
Muhlenkamp Fund, based in Wexford, Pa., is a relatively small fund that invests in mid-sized value stocks. It has gained 18.1% so far this year.
The Schwab 1,000 fund, managed by Charles Schwab & Co. in San Francisco, is an index fund. It seeks to replicate the performance of the broad market. The fund, which invests in the 1,000 largest U.S. stocks, is up 16% year-to-date.
The Domini Social Equity fund also is an index fund, seeking to mimic the Standard & Poor’s 500 index but removing socially “unacceptable” stocks, such as tobacco issues.
In general, index funds are more tax-efficient than actively managed stock funds, by definition, Kinnel notes--another plus for the index strategy, especially for an investor’s “core” stock position within a diversified portfolio.
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Club Favorites: PepsiCo Inc. dethroned Motorola Inc. this year as the most-owned stock among U.S. investment clubs, the National Assn. of Investors Corp. reports.
The NAIC, umbrella organization for more than 36,000 clubs, also said that long-time club favorite McDonald’s Corp. dropped to eighth place on the most-owned list, from fourth place in 1997.
Intel Corp. ranked as the No. 2 stock among clubs this year, up from No. 5 in 1997. Five other major tech stocks made it into the NAIC’s Top 100 list this year for the first time: Oracle Corp., Gateway 2000, Compaq Computer, Cabletron Systems and Sun Microsystems.
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Funds With an Eye on Uncle Sam
These stock mutual funds have been among the most “tax-efficient” as tracked by Morningstar Inc., and all have beaten the average stock fund’s return over the last five years. Tax efficiency is the percentage of a fund’s stated return that an investor in the highest federal tax bracket would keep, after accounting for tax payments on distributed capital gains. Most tax-efficient funds seek to minimize annual capital gains payments and focus on long-term growth of the fund’s share price.
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5-year 5-year tax- annualized efficiency Fund Phone number Type return percentage White Oak Growth (888) 462-5386 LG +26.3% 99.4% MFS Emerging Growth B (800) 637-2929 MG +25.5 98.5 Muhlenkamp (800) 860-3863 MV +20.5 98.0 Baron Asset (800) 992-2766 SG +25.0 97.9 L. Roy Papp Stock (800) 421-4004 LB +19.4 97.0 Domini Social Equity (800) 762-6814 LB +21.3 97.0 Kaufmann (800) 237-0132 SG +21.6 96.9 Dreyfus Appreciation (800) 373-9387 LG +22.6 96.7 Schwab 1000 (800) 435-4000 LB +21.3 96.5 Legg Mason Value Trust (800) 577-8589 LV +27.9 95.0 Average U.S. domestic stock fund +18.5 84.6
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Returns through March 31. Fund types: LG--large-cap growth; MG--mid-cap growth; MV--mid-cap value; SG--small-cap growth; LB--large-cap blend; LV--large-cap value
Source: Morningstar Inc.
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Tom Petruno can be reached at tom.petruno@latimes.com
