WealthManagement Magazine

Tax-Efficient

After-tax return is where the hoof meets the road in today's bull market. More and more fund managers are looking to figure ways to reduce the tax ramifications of their portfolios. Those unrealized taxable gains built into their funds are starting to catch notice, especially during this time of year."We're looking at coming out with a new [tax-efficient] fund," says Phillip Neugebauer, a vice president

After-tax return is where the hoof meets the road in today's bull market. More and more fund managers are looking to figure ways to reduce the tax ramifications of their portfolios. Those unrealized taxable gains built into their funds are starting to catch notice, especially during this time of year.

"We're looking at coming out with a new [tax-efficient] fund," says Phillip Neugebauer, a vice president at PIMCO Advisor Funds in Stamford, Conn. Already PIMCO offers Parametric, a tax-efficient management firm based in Seattle. Demand is strong enough to support more portfolios, he says.

PIMCO is among many fund groups looking to offer more tax-efficient products to investors. Several brokerage firms and money management firms are looking at developing new products as well. At a recent investment management conference in New York, an entire discussion was devoted to the subject of tax-conscious investing. An effort at the investment adviser level is underfoot to lobby investment companies for more tax-efficient portfolios. Meanwhile, Chicago-based Morningstar is tracking untaxed gains within mutual funds, and has begun reporting after-tax returns as well.

But being tax efficient isn't easy. To be sure, managers with low turnover (like index funds) are more tax efficient than those who move in and out of positions. According to Bank Street Advisors Research in New York, the average equity mutual fund manager has a turnover rate of 92%. That means dramatic change will have to be made regarding how funds are managed. Only 14 portfolios are classified as tax efficient by Morningstar. Others claim to be tax efficient, but more as a result of their investment style.

Still, of all managers who tout some type of tax efficiency, few are palatable to investment advisers or brokerage firms. "The tax-efficient funds I've seen are mediocre at best," says Frank Campanale, president of the Consulting Services Division at Smith Barney in Wilmington, Del. "Out of 30 managers who come to us, maybe two do what they say they do. The rest say their performance lagged because they are tax efficient. It's harder to find managers thanwe thought."

Adds Dennis Bertrum, president of Bank Street Advisors, an investment partnership: "Most of these managers grew up in the defined benefit world, and so they didn't have to be concerned about taxes. We're talking about a whole new discipline here."

The Problem with Funds The neatest way to slay the tax dragon is to match gains to losses through a process known as "harvesting." Here, the manager "matches" gains and losses throughout the year. But this becomes cumbersome for mutual fund managers who buy and sell blocks of stock daily and have to allow for liquidity. Private managers and investment partnerships that restrict inflows and outflows may have an easier time matching gains to losses.

Of course, mutual funds don't take on gains until they sell securities. And these gains aren't passed on to shareholders until shareholder distributions are made-typically at year-end. Many funds have hefty realized gains that will be sent any new purchaser's way without the benefit of return. That's why many investment advisers are lobbying for more fund choices.

"We are trying to get fund companies to offer more tax-efficient portfolios," says Peggy Ruhlin, an investment adviser with her own firm, Budros & Ruhlin of Columbus, Ohio, who is pushing for more tax-efficient products. "It's something that our clients are calling for."

Taxes are the largest shareholder expense of an investment in a mutual fund, averaging 250 basis points a year, according to Bertrum. Lop off a 1% management fee and 50 basis points for trading cost, and it takes a 13% return to get 9% after taxes, he says.

The recent budget accord has shifted attention to taxes on capital gains versus income. The top capital gains tax on profits from the sale of securities goes to 20% from 28% and creates a 10% rate for taxpayers in the 15% tax bracket. As well, the holding period to qualify for capital gains treatment lengthens to 18 months, from the current 12 months. In four years, a new top rate of 18% will take effect for assets bought after the year 2000 and held at least five years.

Tax strategies aren't something funds "have been responsive to in the past," says Ruhlin. "But with the new capital gains rule, I think they are going to get more serious about this."

But will tax implications get in the way of managers? Bertrum warns that the industry could end up with products that give investment decisions only secondary emphasis. "It should be the other way around," he says. "Otherwise, you're getting in the manager's way."

Neugebauer argues that what should come first is what the investor wants. "Tax efficiency becomes the discipline," he says. "What we add on is a value or growth wrapper-it's all how you look at it."

And investors might want more tax relief. No doubt many are enthusiastic about their returns at this point-until they get the tax bite.

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