Tax-efficient mutual fund portfolios have become a hot topic, especially since 2000, when many investors suffered the paradox of tax hits from plunging funds. Even so, tax-managed funds have not grown in either number or assets. So the question remains: what value does tax-management really deliver to investors?
The Securities and Exchange Commission's rule on after-tax disclosure has established a consistent set of criteria for reporting and comparing after-tax performance, paving the way for both marketing efforts and further scrutiny by investors.
From a pure tax minimization standpoint, such funds have generally hit their mark. "The funds that look to minimize taxes and take extra steps to maximize after-tax performance generally do a pretty good job at doing that," said William Harding, an analyst with Chicago-based Morningstar.
Morningstar tracks a universe of 63 so-called tax-managed funds, but not all of those even carry a tax-related appellation; the company lists funds that, "by their approach and strategy, are tax-aware funds," explained Harding. Such funds include Schwab 1000, Third Avenue Value, and Muhlenkamp.
Half of mutual fund assets sit in taxable accounts, but tax-managed funds make up only 1% of equity mutual fund assets, said Duncan Richardson, chief equity investment officer at Eaton Vance Mgmt. in Boston.
The proportion does vary by asset class, however. For example, tax-managed funds account for almost 8% of small-cap value assets, the highest percentage. The lowest percentage is in the mid-cap growth sector, where tax-managed funds command less than one hundredth of a percent of assets.
This dearth of tax-managed funds and assets might demonstrate to some that tax management is an ephemeral fad. Still, others maintain it represents fertile ground.
"There are two kinds of people: those who believe in tax-managed investing and those who haven't heard about it yet," said Richardson, whose firm offers eight different tax-managed funds.
What About Performance?
However, not everybody shares Richardson's enthusiasm. In 1998, the Dallas-based fund firm Undiscovered Managers published a white paper deconstructing the justifications for investing in tax-managed funds. The paper, "Mutual Funds and Taxes: Myths, Life Cycles, and Strategies," concludes that tax-aware fund management should be considered only as an incidental to strong pre-tax performance.
"That right there is an opinion about managing for tax efficiency because, if you're making the statement that the best way to get good after-tax returns is to get good pre-tax returns, then taxes be damned," commented Richard Bregman, a co-author of the paper.
In fact, tax-managed mutual funds have not performed well through the past several years, according to Morningstar data. In 1997, the average returns for tax-managed portfolios outperformed within their asset classes across the board, but returns have since become less predictable.
Richardson blamed irregular performance in part on complexes that brought new tax-managed funds to market during the bull market, but, because of a lack of experience, were unable to deliver. "They seemed like a good idea" to the fund managers, but "then they went over the cliff for various reasons," Richardson said.
Bregman, on the other hand, characterized tax-sensitive investing as a sheer marketing ploy.
Richardson disagreed, saying tax-managed investing is an important goal of Eaton Vance's portfolio managers. For instance, all portfolio managers at the firm shoot for the same performance goal of top quintile pre-tax returns, regardless of the fund's tax sensitivity. But the tax-sensitive managers also aim to achieve top quintile after-tax returns, Richardson said.
Looking for Some Humility?
Richardson also suggested that the wash sale rule that managers of many tax-managed portfolios apply might introduce some humility to other portfolio managers. It could encourage them to pay closer attention to their holdings and to rectify their mistakes, he said.
The Internal Revenue Service's wash sale rule dictates that after divesting a given stock, an investor may not repurchase that holding for at least 30 days. Tax-managed funds often take advantage of this rule, selling stocks that have lost value to reap tax losses, with plans of later reinvesting.
Richardson said the "time-out" period imposed by the wash sale rule forces him to be more objective about his investment decisions and rarely results in a missed investing opportunity because the funds he manages all have three- to five-year investment objectives.
"It helps me as a manger to keep a clear head about the long-term merits of a stock. It also helps the managers not to sit around and worry about what went wrong," he argued.
"It's a little bit scary, isn't it? Because it's a declaration that the human element of investing is out of control, unable to see," agreed Bregman, who felt that the lack of humility in fund management points more to the failings of portfolio managers than the advantages of tax-aware investing.
"Having the humility to reverse yourself and get out of your mistakes is every bit as important as capitalizing on your winners. It's one of the hardest decisions for either individuals or professional money managers," said Bill Nygren, portfolio manager for Oakmark Funds in Boston.
Although Nygren manages funds that are not explicitly tax-sensitive, he does use tax management methods to "maximize long-term after-tax rates of return," he said. Even so, Nygren felt that the treatment of tax-managed funds in the consumer press has focused on the ability of tax-managed funds to minimize taxes.
"My pet peeve is the listing of the funds that are considered best-managed for tax efficient returns. I think it's a disservice for the investors," said Nygren, who argued that only strong after-tax returns truly benefit investors.
Members of both camps must agree to disagree, it seems, as tax-managed investing slowly gains momentum with investors.
"If you're a money manager, you're looking to increase the value of the service you provide," said Bregman. That's one statement everyone can agree on.