Long-held theories of how to achieve tax efficiency in mutual fund investing are again being questioned.
According to a new study, "Mutual Funds and Taxes: Myths, Life Cycles and Strategies," the lifecycle of mutual funds -- whether they are new to market or old standbys -- should be taken into account when assessing their tax efficiency. The study concludes that smaller, younger and more concentrated funds run by experienced, disciplined managers are likely to be the most tax-efficient.
The research paper, which looked at index funds, funds with low portfolio turnover, and those boasting "tax efficiency," was released last week.
The report was co-authored by executives of the Dallas-based Undiscovered Managers Funds, led by the group's president and CEO, Mark P. Hurley. In 1994, Hurley, while at Goldman Sachs, wrote a widely-discussed report foretelling the evolution and contraction of the investment management industry. Richard H. Bregman, president of MJB Asset Management of New York, was co-author of the paper.
Tax efficiency among wealthy investors has become very important, said Peter Tanous, president of Lynx Investment Advisory in Washington, D.C. Those with substantial investments in taxable accounts have found the substantial gains they enjoyed in the bull market were considerably diminished by taxes.
Many of these investors who seek tax efficient investments to ease their tax burden do not understand the complexities of doing so, said Len Reinhart, founder and chairman of Lockwood Financial of Malvern, Pa. Whether or not they understand how to achieve tax efficiency, investors will probably see a growing choice of funds promoted as tax efficient, says Reinhart.
According to the new report, one prevalent myth is that to achieve tax efficiency, investors need only select funds with low turnover. While low turnover can be good for investors because gains on appreciated portfolio stocks are not realized unless they are sold, that is not the only factor that determines the tax efficiency of a fund. A fund manager's investment style and the point at which an investor buys shares in a fund can also effect how much the investor ultimately has to pay in taxes.
Funds which have historically held securities for very long times and boasted low turnover, may actually cost investors more in taxes than funds with higher turnover because these funds can carry large embedded gains. Managers who decide to sell highly appreciated portfolio holdings must then pass along those capital gains to all investors. Shareholders who invest in a fund just prior to a security's sale will have to pay taxes on a large gain which they have not enjoyed themselves. The solution to this problem is to find a way for investors in this situation to defer paying taxes, said Hurley.
The report suggests investors buy into a small or even start-up mutual fund that may have the smallest embedded gains and will likely see the largest new cash inflows. Heavy cash inflows could be helpful because the tax burden from gains realized in the future will be divided between more shareholders, said the report.
The report also questions the assumed tax efficiency of index funds. Though many index funds are managed in a tax efficient style (Vanguard Index 500 was cited as an example) there are some actively managed funds which closely rival or even surpass index funds in their tax efficiency. The report based its findings on a proprietary mathematical model which quantifies a fund's past "Tax Efficient Quotient."
The report also said that although tax efficiency is a characteristic to be considered in investing, it can backfire. A fund manager who is overly cautious to produce tax efficiency may sacrifice performance.
"Money managers shouldn't make decisions simply based on tax efficiency," said Hurley. Funds must begin the process of achieving great after tax results by starting out with stellar pre-tax returns, the report said.
Separately managed accounts may be better than mutual funds for investors seeking high tax efficiency, said Peter Forbes, senior vice president with Lynx. That is because the tax situation of each investor is different and mutual funds are not custom-made to best serve individual investors' needs.
"The decision of an individual (to come or go) ultimately impacts the position of the fund," Forbes says.