Last year, investors were in for a rude awakening when it came time to pay taxes on their mutual funds. Not only did they have to pay hefty capital gains taxes for the returns they raked in during the first part of 2000, but the subsequent downturn in the markets eliminated most of what they had accumulated.

In 2000, investors paid an estimated $345 billion in capital gains taxes, representing a 45% increase over 1999. That situation gave a boost to the Security and Exchange Commission's efforts to adopt a rule requiring after-tax performance reporting in certain funds' prospectuses and advertisements. Last year around this time, taxes' impact on fund performance became a popular subject in financial publications and suddenly, or so it seemed, taxes mattered.

A year later, most investors won't have to worry about paying hefty capital gains taxes. And the first part of the SEC's rule on after-tax performance requiring certain funds to provide after-tax performance numbers in advertisements took effect in December and, starting this week, the rule will require most funds to include after-tax returns in their prospectuses.

Taxes Still Fresh in Investors' Minds

Although most investors are not facing the same tax burden they did last year and much of the media attention on the issue has dissipated, taxes' impact on investments is still just as fresh in investors' minds as it was last year. And some firms are finding that those investors are more willing to consider a tax-managed fund than in previous years, according to industry executives and observers.

In fact, a recent survey sponsored by Eaton Vance Corp. found that two out of three investors polled said that the impact of taxes on their funds is more important this year compared to last.

Not surprisingly, much of investors' newfound interest in the matter is directly related to the drop in fund performance over the past couple of years, said Bill Harding, an analyst with Morningstar of Chicago. In the '90s, investors had less of an issue with paying taxes because the returns they were getting more than covered the expense of capital gains taxes, he said. It was only last year that investors began to realize the effect taxes had on their investments, he said.

Harding said he wouldn't be surprised to see funds that are currently managed in a tax-sensitive manner, but do not include "tax-managed" in their name, to adopt the moniker to emphasize that facet of their product, he said. "There are funds out there that might not have tax-managed' in their name, but portfolio managers are aware of the taxes they incur and manage for that," he said. Morningstar tracks 69 funds in the tax-managed category with approximately $37.5 billion in assets, he said.

Limited Awareness

Investors appear to be vigilant about monitoring their funds' tax liability. Seventy-nine percent of the survey respondents claim they examine the taxes they have paid on their investment statements.

Yet most investors are seemingly in the dark when it comes to understanding how investment taxes work. Nearly 30% of investors surveyed were completely unaware of the term "tax efficiency" as it applied to investments and 40% could not cite any investment vehicles that offer high tax efficiency, according to the survey results.

Over the past several years, mutual funds capital gains taxes have, on average, been around 2%, said Tom Faust, chief investment officer of Eaton Vance. Last year served as a wake up call for many investors, he said. "If you're in an environment in which you have single digit returns, a 2% tax hit is much more meaningful," he said.

The challenge to firms offering tax-managed products is raising greater awareness, said. While most investors learned a painful lesson about the implications taxes have on their funds, most don't know how to avoid or minimize their exposure, he said. His firm has been working with the intermediaries who sell its funds to educate its investors, he said. The new emphasis on taxes and fees has given Eaton Vance, one of the fund industry's biggest players in tax-managed funds, something to talk about with its distributors, he said.

Investors who may have been hesitant to switch money out of their funds in the past are now reconsidering, Faust said. In 1999 and 2000, many investors who had funds with strong performance were fearful that if they redeemed their shares, they would wind up paying huge capital gains taxes. That is less of an issue in today's market, Faust said.

Eaton Vance currently has approximately $38.2 billion in tax-managed assets in seven funds, according to Financial Research Corp. data. The firm has filed with the SEC for three additional tax-managed funds, Faust said.

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