Mutual Funds: Avoiding the Tax Man

The mutual fund hangover is starting to subside.

In 2000, fund investors and their advisors awoke to a doozey of a day-after: a market nosedive that caused investors not only to lose money but also socked them with capital gains tax bills for the year.

Once, such an equation meant nothing but pain for investors and their advisors. But it can now produce a nifty tax shelter — a fact that Morningstar figures bring into sharp relief.

Morningstar, the Chicago-based investment research company which tracks funds with an eye on how stock appreciation affects a portfolio's capital gains exposure, has good news. After three years of erratic markets, the average domestic equity fund now has a potential capital gains exposure of -29 percent. That means an investor purchasing a fund now stands to enjoy a bonus in the form of a potential tax shelter.

In fact, says Kunal Kapoor, a Morningstar analyst, “If you buy a fund that has faced big losses, it could be quite a while before you face any capital gains taxes.”

How many years will the tax protection last? That depends, of course, on the fund and the market. Many value funds, which have held up relatively well, still own appreciated stock and could post taxable capital gains right away. Funds with only small amounts of negative capital gains exposure could exhaust the tax shelter in a year or two. And if a bull market suddenly rears its head, stockpiles of losses would quickly be absorbed by new capital gains.

But hundreds of funds have significant negative capital gains exposures. The average mid-cap growth fund has an exposure of -66 percent, while the devastated technology funds sit at of -201 percent.

Funds with significant negative exposure include Janus Mercury, Seligman Communications and Information and Eaton Vance Small Cap Growth. The tax shelter these funds enjoy could last for many years. True, advisors say you should never pick a fund based solely on its tax considerations. But the figures are a useful tool for deciding among investments that seem equal in most other respects.

Separate, Not Equal

To be sure, separate accounts are attractive from a tax standpoint. Many advisors remain loyal to the vehicle, because the accounts can be customized to suit the peculiar needs of individual clients.

“With separate accounts, the management companies will work with you to minimize taxes, and mutual funds can't do that,” says Michelle Murray, a financial adviser with Prudential Securities in New York, a division of Wachovia Securities.

Every year in the third quarter, Murray reviews the tax status of her clients. If a client sold a business and recorded big capital gains, she knows it would be helpful to incorporate some offsetting losses into the portfolio. To achieve the tax goal, Murray contacts the portfolio management company and requests that the manager maximize losses, selling some losing stocks to book a tax loss carryforward.

But this strategy only works if the management company is willing to help. Some cookie-cutter-variety separate account companies are reluctant to put forth special efforts in the direction of generating tax losses. But many others, such as AIM Private Asset Management in Houston, understand the importance of such services to their clients and make a big show of the service.

The typical AIM portfolio has about 60 stocks. When an adviser notifies the company that a client needs to book losses, AIM will identify stocks that are in losing positions. Next, the portfolio manager will typically sell 5 to 20 of the dogs, booking capital losses that can offset gains. Under wash-sale rules, the portfolio cannot repurchase the shares for 31 days. So the portfolio manager takes cash from the sales and invests it in exchange-traded funds that would roughly track the stocks that had been dumped. At the end of 31 days, the stocks may be repurchased.

“By harvesting losses, you can achieve significant tax savings,” says Mark McMeans, AIM's president. “But the client must understand that you are changing the portfolio slightly to accomplish the tax goal.”

The tax efficiency of separate accounts can be improved even more by using overlay managers, which insure that complicated portfolios do not engage in counterproductive strategies. Say, for instance, an investor has six accounts, each run by a different portfolio manager. In some instances, the large-cap value manager may be selling IBM shares at the same time that the large-cap growth specialist is buying. The trade could generate tax bills and trading costs without improving the client's overall portfolio. To cut unnecessary costs, the overlay manager holds all the stocks in the six accounts. Portfolio managers who want to buy and sell stocks inform the overlay manager who executes the orders in the most tax-efficient way. If orders to buy and sell IBM come in simultaneously, the overlay manager can simply hold the shares in the client's portfolio, avoiding needless trades. By improving tax efficiency, an overlay manager can produce after-tax returns that are 30 to 90 basis points ahead of a plain-vanilla mutual fund, according to a study by SEI Investments, an asset manager in Oaks, Pa.

But advisors need to be aware that tax benefits can vary considerably, depending on investment style. A separate account manager who trades rapidly could generate big tax bills and be hard-pressed to outdo a mutual fund that comes with a big stockpile of losses.

In the end, there are two roads to the same destination, but each of them must be traveled carefully.

Down is Up

Courtesy of the bear market, these funds have stockpiles of capital losses that can be used to offset future capital gains