For some academics, American Century Heritage Fund might seem like a fluke. The mid-cap growth fund has an annual portfolio turnover of 230 percent, about double the rate of its peers. Yet Heritage is more tax efficient than most competitors and has outperformed 83 percent of peers during the past five years. According to academic research, Heritage shouldn't be more tax-efficient and shouldn't outperform. Turnover — especially rapid trading — generates brokerage commissions and erodes returns, researchers say. In addition, high-turnover funds tend to produce big tax bills; every time the manager sells a stock, he may book capital gains.

Did the academic researchers get it wrong? Not exactly. On average, high-turnover funds are more costly to operate. But there are notable exceptions. Advisors who screen out high-turnover funds are missing plenty of top performers — and some of the most tax-efficient funds around.

High-turnover Magic

Turnover is a crude measure of a fund's trading patterns. To appreciate how misleading the data can be, consider the method for calculating turnover. Under SEC rules, a fund starts by counting its total purchases and sales. You might guess that the next step would be to add the two numbers together. But that is not what the SEC requires. Instead of tallying purchases and sales, the company must take the lesser of the two figures and divide it by assets. Say a company has $1 million in purchases, $1 million in sales and $1 million in assets. The turnover is said to be 100 percent. That seems reasonable because the whole portfolio changes roughly once a year. But consider a fund that is rapidly gaining assets. To absorb all the cash, the fund makes $2 million in purchases and no sales. Under SEC rules, the lesser number must be used, and the turnover is zero. “The turnover rules may have made sense 50 years ago, but they are outmoded now,” says Russel Kinnel, mutual fund research director of Morningstar.

Whether or not the turnover data are reliable, the costs of fast trading are rapidly diminishing. Lately, many fast-trading funds have become tax-efficient, too. Traders sell losing stocks, generating capital losses that can be used to offset capital gains. By playing its cards right, a fast-trading fund can end the year with no tax bills at all. Besides lowering tax bills, many funds are working to reduce another cost of high turnover: brokerage commissions. Today, big institutions can trade with each other on electronic platforms where transactions may cost next to nothing.

In the near future, the penalties of rapid trading could get much smaller, says Alan Seigerman, chief operating officer of ReFlow, a San Francisco company that helps mutual funds manage trading. ReFlow just began offering a service that enables funds to do “in-kind” trading, the strategy that makes it possible for exchange-traded funds and open-ended mutual funds to reduce taxes and trading bills.

Here is how it works. Suppose a fund shareholder wants to withdraw $100,000 from a fund. Traditionally, the fund would have to sell $100,000 worth of stock in order to get the cash to pay the shareholder. This might generate trading costs that would reduce the returns of the fund. But if a fund hires ReFlow, the fund can give ReFlow $100,000 worth of stock. In return, ReFlow gives the fund $100,000 in cash with which to pay the shareholder. From the fund's point of view there is no sale of stock and no brokerage commissions or capital gains. There is an in-kind trade. The fund does have to pay ReFlow an ongoing fee, but ReFlow keeps its fees low.

High Returns, Low Taxes

So far, ReFlow has not succeeded in making mutual funds as tax efficient as ETFs. But the high-turnover mutual funds described below are giving ETFs tough competition, providing top returns while avoiding big tax bills.

American Century Heritage achieved its compelling record by seeking stocks that are improving their businesses, reporting higher sales and earnings. The aim is to buy companies that will outperform the market for at least the next six months. The fund typically holds about 80 stocks and places big bets on the top 20 holdings, often keeping more than 3 percent of assets in a single name. The biggest positions are considered stars that have a strong chance of growing. The fund often holds the best shares for years, a strategy that lowers taxes.

The rest of the portfolio is made up of many small positions in which the managers have less confidence. If one of the lesser names slips even a bit, the fund sells immediately. The managers aim to sell when they can book a quick loss. These quick sales explain why American Century has high turnover. “By selling the losers and letting the winners run, we can be tax efficient,” says Glenn Fogle, an American Century portfolio manager.

Another fund that dodges the tax man is Aston/Veredus Select Growth. Portfolio manager B. Anthony Weber looks for companies that are surpassing Wall Street's earnings estimates. When one of his holdings disappoints, he sells and books the loss. “I don't care whether the price-earnings multiple is 10 or 30,” he says. “As long as the company is delivering earnings surprises we will consider it.”

Eaton Vance Growth A generates a high turnover rate as it seeks stocks that can record annual earnings growth in excess of 20 percent. As soon as a stock shows any problems, it is dumped. “Whenever we find good new ideas, they will push out the weakest ideas in the fund,” says portfolio manager Arieh Coll. “There is always something coming into the fund and something going out.”

Fidelity Large Cap Value doesn't place big bets on particular sectors. Instead, the fund roughly tracks the industry weightings of the Russell 1000 value index. Portfolio manager Bruce Dirks aims to beat the benchmark by holding about 100 of the most promising value stocks. Frequently, he has succeeded. That has attracted a strong flow of assets. To avoid holding cash, Dirks takes the new money and buys ETFs that match the Russell 1000. When he finds good stock candidates, he sells the ETFs and puts the cash into promising shares. “Much of our turnover is related to the fact that we have had sizable asset inflows,” he says.

While Fidelity looks for the best value stocks, Wells Fargo Advantage Growth only wants the top growth names. Portfolio manager Thomas Ognar typically buys companies whose revenues are growing 10 percent to 30 percent annually, and earnings are climbing at a rate of 15 percent to 30 percent. “We want to find sustainable growth that is being underestimated by the market,” Ognar says.

Ognar bought Google at its initial public offering in August 2004. For all the hype, the stock was bound to benefit from the growth of the Internet, he figured. Today Google is still a big holding. When such high-flyers falter, Ognar sells immediately. That explains why this fund generates a relatively high turnover.

FIGHTING THE TAXMAN WITH HIGH TURNOVER FUNDS
Fund Name Ticker Category Ratio Turnover Ratio Tax cost 3-year Return 5-year Return % category 5-year return
American Century HeritageI TWHIX Mid growth 230% 0.21% 16.0 10.6 23%
Aston/Veredus Select Growth N AVSGX Large growth 270 0.01 9.9 8.0 9
Eaton Vance Growth A EVGFX Mid growth 208 0.07 12.2 10.6 24
Fidelity Large Cap Value FSLVX Large value 175 0.71 14.1 10.2 17
Wells Fargo Advantage Growth Inv SGROX Large growth 123 0.00 9.8 7.7 11
Vanguard 500 Index VFINX Large blend 5 0.36 9.0 6.7 42
Source: Morningstar. Returns through 2/28/07.