Faced with big tax bills for the first time since 2000, investors in 2005 flocked to tax-efficient funds, according to a Wall Street Journal report.

Despite sluggish stock returns, many investors have burned through the tax credits rolled over after losses in the most recent bear market and are clamoring to control their tax bills.

Tax-efficient funds offer a solution. In fact by October of 2005, investors poured $1.1 billion into these types of funds, compared to outflows of $743 million in 2004, according to Financial Research Corp.  Investors had 77 such finds to pick from at the end of 2004, compared to only 42 in 1999, according to New York-based fund research firm Lipper Inc.

The $40 billion in assets controlled by tax-managed funds still pales by comparison to the $2.94 trillion invested in other traditional, taxable funds, but fund managers may attract more attention to tax-managed funds through new products.

Funds that offer "covered call writing," for example, allow investors sell to options on stock indices. This make-money-now approach can lure investors turned off by tax-managed funds' buy-and-hold reputation.

Moreover, tax-managed funds seem to perform well, compared to normal mutual finds.  Lipper's index of large-cap mutual funds lost approximately 3.8% overall during the five-year span that ended on Oct. 31 of this year, whereas tax-managed funds, as a category, lost 3.4%.  Likewise, while traditional mutual funds have an average expense ratio of 1.41%, the ratio among tax-managed funds is 1.32%.

Investors considering such funds should beware: the tax laws are constantly changing, and a bill currently before Congress proposes postponing taxes on fund gains until after the investor sells his or her shares, which would make moot the organizing strategy behind many of these funds. Furthermore, those investing through tax-deferred plans, such as 401(k) plans or IRAs, should not consider tax-managed funds, since managers of these funds may pass on pre-tax returns in order to control the fund's overall tax liability.

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