Dodging the Taxman

By now, you may have heard more than a few clients complain about the magnitude of the tax bills for short-term capital gains that they'll be paying in April. The rising market produced a gusher of trading profits in many funds, but the clients wind up paying the taxes. To avoid tax complaints next year, consider the after-tax returns your funds will generate. For example, instead of owning the Vanguard 500 Index fund, which has $110 billion in assets, investors should own the Vanguard Tax-Managed Growth & Income fund. While the tax-managed vehicle tracks the Standard & Poor's 500-stock index closely, the fund has consistently outdone the Vanguard 500 by 15 basis points after taxes. “Taxable investors should definitely prefer the tax-managed fund,” says Joel Dickson, a principal and tax specialist at Vanguard Group.

Of the $13 trillion in mutual funds, about half is in taxable accounts. But less than $20 billion of assets are in 60 funds with “tax managed” in their names, according to Morningstar. Part of the reason for the lack of interest may be connected to market conditions. Following the downturn that began in 2000, investors had little reason to worry about taxable gains. During 2001 and 2002, many funds reported red ink. For the next two years, tax-loss carryforwards continued to offset gains, reducing annual tax bills. But that is beginning to change. According to Lipper, fund shareholders paid $15 billion in taxes in 2005. For 2006, the total bill could top $20 billion. For the decade ending in 2005, Lipper figures that the taxman shaved more than 1.6 percentage points annually from the total returns of taxable shareholders.

Tax-managed funds have proved that they can cut tax bills sharply. Many of the funds have never hit shareholders with a taxable gain. To avoid paying Washington, portfolio managers can take a buy-and-hold approach. As long as the fund doesn't sell, it will not record taxable capital gains. Another tax-management technique is known as loss harvesting. Say a fund owns Ford, a stock that has dropped sharply in recent months. The manager sells the shares and books the loss. If he still likes the stock's long-term prospects, the manager may wait more than 30 days and buy the shares back. By delaying the repurchase, he avoids running afoul of IRS wash sale rules.

Can managers cut taxes and deliver strong total returns, too? Yes. Tax-avoidance techniques don't necessarily hurt returns. On the opposite page, you can see funds that trounced their category averages while sparing shareholders pain at tax time.

Five to Choose From

During a difficult period for growth investors, William Blair Tax-Managed Growth has delivered healthy results. Portfolio manager Greg Pusinelli accomplished the job by sticking with dominant companies that are increasing earnings at annual rates of about 15 percent. The portfolio includes powerhouses like PepsiCo and Amgen. If a favorite stock dips, Pusinelli often buys new shares. Then he sells some of the older, high-priced shares and books the loss. “If the market moves against us for no reason, we will use the occasion for tax advantages,” he says.

Eaton Vance Tax-Managed Value has outdone competitors by focusing on blue chips with strong franchises and good growth prospects. Portfolio manager Michael Mach aims to buy market leaders when they have temporarily fallen out of favor. Recently he bought Nokia, a stock that has declined as investors worry that the handset maker may be losing its market share.

To minimize taxes, Mach allows winning holdings to continue running. The fund harvests losses by cutting off losers quickly. The tax strategy may help total returns, he says. “The principles of good investment management and good tax management can go hand in glove,” Mach says.

Throughout its six-year history, Goldman Sachs Structured Tax-Managed Equity has never socked shareholders with any taxable capital gains. The fund accomplished this feat by using a quantitative approach. The system ranks stocks according to their valuations, earnings quality and trends in analyst estimates. In addition, the quants look at transaction expenses, how much it would cost to buy or sell the shares — including the tax consequences. “A trade that would trigger a gain is viewed as having big transaction costs,” says portfolio manager Donald Mulvihill. “The system prefers selling losing stocks where the transaction costs will be low.”

Constantly selling losers, the fund has built up a surplus of tax-loss carryforwards. Such tax losses can be stockpiled and used to offset gains for up to seven years. “Because of the carryforwards, it is unlikely that we will be distributing gains for some time,” says Mulvihill.

During the past five years, Manning & Napier Tax-Managed has outperformed 95 percent of large blend funds by holding a mix of growth and value stocks. When prospecting for growth stocks, portfolio manager Michael Magiera looks for companies with long-term competitive advantages. Growth holdings include Nestle and Automatic Data Processing. “We want to hold stocks for a long time, and that helps to minimize taxes,” says Magiera.

On the value side, Magiera prefers cyclical stocks that are going through their unappealing phase. When oil was priced at $10 a barrel, he bought big producers. As oil prices rose, he sold the energy stocks and bought unloved technology names, such as data-storage giant EMC.

Another diversified fund is Vanguard Tax-Managed Growth & Income, which owns every member of the S&P 500. To reduce taxes, the fund dumps some shares that have suffered dramatic price drops. But the sales are done so that the portfolio always tracks the S&P benchmark closely. To maintain at least some assets in each stock, the managers would only sell part of a position. The fund never holds cash; so if the fund sells GM, the managers would immediately take the cash proceeds and invest them in auto-related stocks. “In any given year, we can keep our returns within 20 basis points of the index and still get good tax management,” says Vanguard's Dickson.

In recent years, selling losing stocks has proved to be an effective investing strategy. That helps to explain why the Vanguard tax-managed fund has outdone Vanguard 500 on a pretax basis for the past decade.

Dickson cautions that the tax strategy may not produce winning pretax returns all the time. But effective tax management can shave costs nearly every year. Over time, the small tax savings can compound into a substantial advantage.

TURBO TAX