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Mutual fund tax efficiency
Is there a list somewhere that shows this information?
January 26, 2004: 8:46 AM EST
By Walter Updegrave, Money Magazine

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NEW YORK (CNN/Money) - Is there a list that shows the tax efficiency of individual mutual funds? If so, how do I get it?

-- Dale Ferguson, Lexington, Kentucky

Interesting isn't it, how a reduction in the tax rate on dividends and long-term capital gains this summer has made investors much more aware of how much of their investment gains they're giving back to the U.S. Treasury?

Once people get a little taste of lower tax rates, they begin to wonder if maybe there aren't some other ways for them to lower the tax bite on their mutual fund gains.

Why does tax efficiency matter?

Before I answer your question, though, let me give a brief explanation of how fund taxes work, so that people not familiar with tax efficiency will know why you're interested in a list of tax-efficient funds.

Basically, you can owe taxes on fund gains in three ways. The first is when you sell fund shares for more than you paid for them. The second is when the fund passes along to you interest or dividend payments it's received. The third is when the fund manager makes a profit by trading securities in the fund's portfolio and that profit is passed along to you in the form of short- or long-term capital gains distributions.

You have control over when you sell fund shares. But you don't control the interest and dividend payments or the capital gains distributions. The fund manager controls those.

In the case of interest and dividends, the manager has control in that he can choose investments that are more or less likely to pay interest or dividends.

And in the case of capital gains distributions, it's largely the manager's propensity to trade that determines the extent to which your fund's return consists of realized capital gains (that is, gains from the actual sale of securities as opposed to paper gains that remain untaxed until the security is actually sold).

Ah, but there is an indirect way for you to gain some control over fund taxes. And that is by investing in tax-efficient funds. Basically, these are funds that minimize taxable distributions through any number of means.

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In some cases, a fund's investing style might make it inherently tax-efficient. If a manager doesn't trade much, there are fewer realized (and therefore taxable) gains passed along to shareholders. Broad-based index funds, such as those tied to the Standard & Poor's 500 index or to the Wilshire 5000 index, also tend to be pretty tax efficient because the manager buys the index and sells securities only to reflect changes in the index or to handle redemptions.

Finally, there's a third type of tax-efficient fund -- a tax-managed fund. Managers of these funds use a variety of techniques, including harvesting losses in some securities to offset gains in others, in order to keep taxable distributions to a minimum.

These distinctions aren't academic; they can dramatically affect the amount you shell out in taxes. For example, if you invest in a fund where the manager does lots of short-term trading -- that is, sells securities the fund has owned for a year or less -- much of your gains will come in the form of short-term capital gains, which are taxed at ordinary income rates as high as 35 percent.

If the fund gets much of its gains from selling securities the fund has held longer than a year), then much of your return will come in the form of long-term capital gains, which are taxed no higher than 15 percent. Under the new tax law, most dividends are also taxed at no more than 15 percent. So investing in funds that take advantage of the tax laws can translate to you keeping more money in your pocket.

A "tax-cost ratio" might be the thing

So, is there a list of tax-efficient and/or tax-managed funds available? I'm not aware of any organization that publishes an updated list of such funds. But Morningstar, the big fund research firm, does calculate what it calls a "tax cost ratio" for individual funds.

I won't go into the details of how it's calculated, but basically, the lower this ratio, the less of the fund's return is given up to taxes. By ranking funds by their tax cost ratios, you can see which are more tax efficient than others.

Unfortunately, the fund screener available free on Morningstar's Web site does not let you screen by the tax-cost ratio (although it does give the ratio for individual funds). Morningstar's premium screener allows you to sort funds by their tax-cost ratio, but this service costs $11.95 per month.

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Similarly, Morningstar's CD-based Principia service allows you to rank funds by their tax cost ratio, but that service comes with a price tag of $445 a year or more, depending on which version you choose.

There are two roundabout ways to get at tax efficient funds without paying those fees, although neither is ideal. One is to screen on Morningstar's site for funds with low portfolio turnover. Many of these funds will tend to be more tax-efficient, although not all will be. And you'll miss tax-managed funds that have higher turnover due to the fact that they actively sell losers to create losses that can be used to offset gains in winning securities.

The second way is to simply do a search at Morningstar's site for funds that include "tax managed" or "tax efficient" in their names. This way, you'll pick up many, though not all, of the funds managed specifically to lower taxes. Once you've got a list of names, you can then check out each fund's tax-cost ratio individually.

One final note. While investing in a fund that's tax efficient can be a smart move, you also want to be sure the fund has a credible performance record versus funds with similar styles and reasonable expenses. And keep in mind that, no matter how tax efficient, the fund should fit into the rest of your portfolio, in terms of the types of securities it buys (small, mid or large cap) and its investing style (growth or value).

After all, the last thing you want is to go to the trouble of finding tax-efficient funds only to end with a lopsided portfolio that exposes you to unnecessary investing risk.


Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He also answers viewers' questions on CNNfn's Money & Markets at 4:40 AM on Monday afternoons.  Top of page




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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.