LEN BOSEOVIC
Pittsburgh Post-Gazette
23-DEC-05
Peace on earth and goodwill to men is the first thing to keep in mind at Christmas. For investors who own mutual funds in taxable accounts, December should also be a time to remember that it's not what you make, but what you keep.
Christmas is when mutual fund companies send them presents they pay for: notices of how much the funds will be distributing in dividends and capital gains. If you own a fund in a tax-deferred account such as a 401(k) plan, you won't pay taxes on those payouts this year.
But if you're in a taxable account and you've got to pay the man April 15, taxes should be foremost on your mind.
Based on fund distributions in 2004, fund investors in taxable accounts paid an estimated $9.6 billion in taxes for that year, according to investment research firm Lipper, up 48 percent from what they paid in 2003.
Moreover, Lipper says its estimates are based on very conservative assumptions. Taxes can reduce a fund investor's return by 1.8 to 2.5 percentage points, it says _ a severe enough haircut that can turn decent returns into middling ones and so-so results into downright disappointments.
"If you can increase your returns 2 percent a year, that's enormous," says Duncan Richardson, chief equity investment officer for Eaton Vance, the Boston-based fund and investment manager.
Over the long haul, Lipper says, taxes are a bigger drag on stock fund performance than management fees and commissions funds charge incoming and outgoing investors. That's true despite the fact that 2003 tax cuts lightened the levy on capital gains and dividends.
"The tax drag is just a really big issue," says Lipper senior research analyst Tom Roseen. "People just don't have it on their radar screen yet and they really should."
When Eaton Vance surveyed investors recently, 90 percent said the impact taxes have is important to them. "But they don't have a clue as to what to do about them," Richardson says.
The Securities and Exchange Commission has been trying to raise investor awareness. Since 2001, the federal regulator has required funds to disclose after-tax returns as well as the pretax returns featured so prominently in industry advertising.
One important point: Although after-tax returns are disclosed, most fund managers are compensated based on their pretax returns, a pay scheme that doesn't do investors in taxable accounts _ about half of all mutual fund investors, according to Lipper _ much good.
Eaton Vance, T. Rowe Price and other fund shops offer "tax-managed" or "tax-efficient" funds. Assets in these funds totaled $42.3 billion as of Oct. 31, only about 1 percent of all the assets held in taxable fund accounts, Lipper says.
The funds typically have low turnover, a measure of how often a stock or bond stays in a fund's portfolio. A 100 percent turnover means a fund gets a complete face-lift annually. A fund with a 50 percent turnover sells half of its holdings each year.
Turnover is important for two reasons. First, frequent trading drives up a fund's expenses. Moreover, if fund managers are doing their job, the buying and selling generates more profits than losses, exposing investors to capital gains taxes.
"The more trading there is ... the more tax issues there are to deal with," says Joseph Grieco, vice president of Sky Wealth Management.
While capital gains are unavoidable, managers of tax-managed or tax-efficient funds offset them by culling losers from their portfolios as they harvest the winners. That generates losses that can be used to offset gains. Limiting short-term gains, which are taxed at higher rates than investments held longer than one year, is a prime focus of managers of tax-efficient funds.
Over the past few years, fund managers have used losses rung up during bear market that began in 2000 to offset gains. However, Roseen says those accumulated losses are just about gone, which means increased distributions to investors in the years ahead.
In order to market themselves as tax-managed or tax-efficient, funds must commit to keeping turnover low and minimizing short-term gains. Some managers won't make that promise, but do it anyway.
Federated Investors' $450 million Muni and Stock Advantage Fund (Ticker: FMUAX) holds 65 percent of its assets in municipal bonds that are tax-free, even for investors subject to the Alternative Minimum Tax. The other 35 percent is in common stocks whose dividends qualify for the lower dividend tax rates enacted in 2003, the year the fund was launched. According to Lipper, the fund's turnover is just 39 percent.
Last year, investors kept 95 cents of every $1 paid out in distributions, says R.J. Gallo, a co-manager of the fund. He says an investor in the 35 percent tax bracket would have to earn a yield of 4.4 percent on taxable bonds to match the fund's 3.1 percent yield.
Taxes aren't as big of a concern for investors in lower tax brackets, but regardless of your tax status, you should be aware of how much taxes reduce returns. That will give you a better understanding of how fund managers go about their business, including whether they have the expensive habit of being quick with the trigger finger when it comes to trading.
While it's too late to do much about how much of your earnings you'll keep this year, it's not too early to start planning how to keep more in 2006.
(Distributed by Scripps Howard News Service, www.shns.com.)
