With mutual fund performance being what it is, clients may not be worried about capital gains taxes. They should be. Too many clients have learned that it is possible to lose money on a mutual fund investment and pay taxes. Advisors would be wise to be reminded that taxes remain one of the biggest costs faced by fund investors. According to Morningstar, an investor in the top tax bracket who owned the average large cap growth fund gave up 36.1 percent of the gains in taxes.

To help the investing public understand this, the SEC implemented new rules this year that require funds to disclose data on how taxes affect their returns. Certainly, this is a good thing. But some industry experts caution that the regulations offer only a general picture and that the information could, in one important case, actually mislead advisors and their clients.

That funds must now disclose their after-tax returns in their prospectuses is pretty straightforward. (Keep in mind that only funds that market themselves as tax-efficient need to mention after-tax results in advertising.) Where the advisors can be misled is in the so-called post-liquidation results that the SEC has also demanded be disclosed. The post-liquidation performance is defined as the return for someone who sells after one year or longer.

Fund companies are particularly concerned about how the post-liquidation results are interpreted. “The post-liquidation numbers can overestimate the actual tax impact on a buy-and-hold investor,” says Joel Dickson, a principal at Vanguard Group who specializes in tax issues.

Here's why: Consider that funds only record taxable capital gains after securities are sold for profits. In a tax-smart fund, long-term shareholders can enjoy rising share prices and face small or no capital gains taxes if the manager rarely sells any stocks. However, the post-liquidation return table must show the after-tax returns for an investor who sells at the end of one year, a figure that could generate a big tax bill — but not if he had stayed invested. By the one-year measure, an otherwise efficient fund might have a relatively poor after-tax return.

Instead of looking at the post-liquidation number, investors should consider the pre-liquidation figure, or the plain vanilla after-tax return result. This shows the annual return most long-term investors receive. James Peterson, vice president of the Charles Schwab Center for Investment Research, says that investors can get a more precise picture of a fund's performance by simply subtracting the after-tax returns from the pretax number. So if a fund delivered a total return of 12 percent and an after-tax figure of 10 percent, then it would have lost 2 percentage points to taxes. By using this number, advisors can compare similar funds and select the most efficient. “Funds that have been tax-efficient in the past tend to deliver higher after-tax returns in the future,” Peterson says.

Along with considering the after-tax return data in the prospectus, some advisors also look at other data compiled by Morningstar, including potential capital gain exposure and turnover ratios. But these are not necessarily reliable. Consider the figures on potential capital gains, which indicate the taxable gains a shareholder would face if the portfolio liquidated tomorrow. Occasionally, funds with big potential gains can prove to be tax bombs. For example, a fund may sell most of its holdings when a new manager takes over.

But funds rarely sell everything at once. Often the potential gains never are booked and distributed to shareholders at all. For example, Vanguard 500 Index, the largest mutual fund, had gains equivalent to more than 30 percent of its assets during the bull market.

Turnover is another indicator that provides imperfect guidance. While tax-efficient managers aim to avoid needless trades, some high-turnover funds consistently report low tax bills. Ark Small Cap Equity A, for example, has a turnover of more than 300 percent, yet it reports better-than-average after-tax returns. The fund's rapid trading does produce above-average pretax gains, but it also books plenty of losses, which help to reduce the tax bill.

Tax-Efficient Funds Pay Off
Fund 5-year pretax return 5-year after-tax return Tax efficiency*
Fidelity Magellan 9.30% 7.21% 84%
J.P. Morgan Tax-Aware U.S. Equity 9.13 8.92 97
Source: Morningstar. Data through Jan. 31, 2002
*percentage of pretax return kept after taxes by investor in the top tax bracket

Russell Kinnel, Morningstar's director of fund analysis, says that figures on turnover and potential capital gains can provide some telling information about a fund's strategy, but perhaps the most reliable predictor of future tax efficiency is obvious: Does the fund announce its intention to manage taxes? Morningstar counts 181 funds that claim to do that. “Almost all the tax-managed funds do a superior job of controlling taxes,” Kinnel says.

Some funds on the list, such as Vanguard Tax Managed Capital Appreciation and Liberty Tax-Managed Aggressive Growth, announce their intentions in their names. But others, such as Oakmark Select and Third Avenue Value, don't incorporate the tax mission in their titles; advisors can learn which funds manage taxes by consulting Morningstar.com, or by studying shareholder communications and prospectuses.

To reduce bills, the tax-managed funds aim to hold winning stocks for years and to aggressively book losses by selling poor performers. Anytime they are about to sell at a gain, they try to find an offsetting loss. Another trick to dampen taxes: Funds that sell part of a holding will sell the shares with the highest cost basis, a technique that results in a lower gain.

Some advisors may worry that relying on tax-efficient funds can result in lower pretax returns. But many of the tax-managed funds have delivered strong pretax returns. This may be no accident. The techniques of the tax-managed funds — holding winning stocks for the long term and making an effort to sell losers — can also produce healthy returns. Therefore, the tax-smart funds may also provide intelligent vehicles for maximizing returns.