Inoculating Your Portfolio Against Taxes
By Robert Barker
Tax time has come and is now blissfully gone (except for those poor souls who filed for an extension). For mutual-fund investors, suffering after a couple of years of more red ink than black, it was less trying than any in memory. Fewer capital-gains distributions meant lower tax bills: a silver lining, albeit a very dim one, to the recently cloudy investment world.
Just the same, this is a better time than many for fund investors to plan with the goal of keeping a lid on their taxes related to mutual-fund holdings. As many investors have learned to their dismay, fund investments can be taxed three ways. First, any dividends -- whether derived from interest income earned on bonds or from stocks in the fund portfolio -- have to be passed on to the fund holders. They're taxable at ordinary income tax rates.
Next, funds also must pay out to investors any net capital gains (that's capital gains minus capital losses) generated by trading assets in the portfolio. These are taxable at capital-gains tax rates regardless of whether the investor sold any fund shares. Finally, investors also owe a capital-gains tax if they sell fund shares at a profit.
Add it all up, and the aftertax returns on mutual funds become a lot less impressive than the pretax returns that usually get highlighted by fund sponsors. Fairly typical is the $78 billion Fidelity Magellan (FMAGX ) fund, the world's largest actively managed fund. Over the past five years, it has posted a 10.1% pretax average annual total return, net of its 3% sales charge, according to Morningstar. But after taxes on distributions, its annual average return for the period sank to 8%.
Fortunately, some mutual-fund companies have come up with a partial solution: tax-managed mutual funds. These are operated with an eye toward minimizing dividends and distributions while still aiming to keep overall returns high. The funds managers are usually quick to take losses in the portfolio and use them to offset any capital gains that can't otherwise be avoided.
When they first began appearing a few years ago, skeptics wrote them off as a marketing gimmick. Critics suggested that managing the portfolio to minimize taxes would lead stock-pickers astray from their main goal of high returns. To see how they have been performing, I ran a computer search using Morningstar data. Not counting varying share classes, I found 74 funds listed as actively tax-managed.
What did I discover? I'm pleased to report that overall this class is doing quite nicely. The 20 funds that had been operating for at least five years as of Mar. 31 were, on average, in the top 36% of funds within their respective categories. The group averaged a 9.8% pretax annual total return over the five years. How much after taxes on distributions and dividends? A bit over 9%.
Naturally, some of these funds are better than others. By better, I mean they showed a superior risk-reward balance or charged lower fees and expenses. For anyone intent on making more money after taxes and now curious about these kinds of funds, I've assembled a short list of candidates for further research:
Barker covers personal finance in his Barker Portfolio column for BusinessWeek. His barker.online column appears every Friday, only on BusinessWeek Online
Edited by Patricia O'Connell