Tax-managed funds don't guarantee tax efficiency, but they can be a good choice for taxable investors.
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By Karen Wallace | 02-15-17 | 05:00 AM | Email Article

Question: Why would someone invest in a tax-managed fund? Are they more tax efficient than index funds?

Answer: A "tax-managed" fund is one that is run with an eye toward reducing the drag of taxes that shareholders can incur from events such as the distributions of investment income (such as dividends) and capital gains realized through the sale of appreciated securities. They can make a lot of sense for investors in taxable accounts--provided they live up to their promise of being tax-efficient. 

Karen Wallace is a senior editor with Morningstar.com. Follow her on Twitter @KarenW60602.

And while many index funds are fairly low-turnover and tend not to pay out distributions, that's not always the case. Sometimes stocks get booted out of indexes with market-cap constraints or factor tilts when the stocks no longer meet the indexes' criteria for inclusion. Exchange-traded funds can tend to be more tax-efficient because of their ability to exchange securities in-kind rather than sell the holdings, but certain types of ETFs are more likely to make distributions (such as currency-hedged funds that employ derivatives contracts).

William Coleman, a portfolio manager on Gold-rated  Vanguard Tax-Managed Capital Appreciation , says one of the things that makes tax-managed funds appealing compared with traditional passively managed index funds is the tax-managed fund managers' ability to more deftly mitigate taxes, especially given the unpredictable nature of tax-law changes. For instance, if, going forward, qualified dividends were to no longer be given preferential tax treatment, or if REIT income was to be taxed at rates even higher than ordinary income rates, a fund following an active tax-managed strategy has more leeway to tilt the portfolio away from income-producing assets. 

"We have flexibility compared with the index," Coleman said. "Our internal risk controls are wider; we can do more tax-loss harvesting and we have more leeway to lower the dividend yield."

Evaluating a Fund's Tax-Efficiency
First off, it's important to put a fund's tax efficiency in the context of its aftertax return. 

"You can put money in shoe boxes in your closet and have great tax efficiency. But what you really want is aftertax returns," explains director of manager research Russ Kinnel. 

Let's evaluate how well Vanguard Tax-Managed Capital Appreciation has done mitigating investors' tax burden by comparing the fund's pretax returns with its aftertax returns. Ideally, you don't want to see a large gap between these numbers.

Vanguard Tax-Managed Capital Appreciation's prospectus states the fund's managers expect that the fund will loosely track the total return performance of the Russell 1000 index, but with lower taxable income distributions. (It buys stocks from that index, but tilts away from those paying higher dividends.) To see how it did compared with a pure index-tracker, let's look at  iShares Russell 1000 , an exchange-traded fund that tracks the Russell 1000.

The tax-managed fund in this case has a higher pretax and aftertax return, and thus a higher "% rank in category" than the index-tracker over all trailing time periods. (The rank in category here works the same way a fund's category rank for total returns works: A ranking of 1 is most desirable and means that the fund's tax-adjusted return is at the top of the category while 100 means it's at the bottom.) 

Another evaluation metric investors can use is the tax-cost ratio. This metric measures how much a fund's annualized return is reduced by taxes that investors pay on distributions. The way it's expressed is much like an expense ratio: The lower it is, the less money the investor has surrendered to taxes. A tax-cost ratio of zero means the fund didn't pay out any taxable distributions for the period. (Of course, that's not to say that you should buy a fund just because its tax-cost ratio is low or zero. You should also consider metrics such as a fund's management, strategy, record, and fees.)  

Vanguard Tax-Managed Capital Appreciation Fund's tax-cost ratio is 0.57, 0.53, and 0.39 over the three-, five-, and 10-year periods.

What's in a Name?
Although the Securities and Exchange Commission has made efforts to make sure funds employ strategies that are in line with what is suggested by their names, you still shouldn't take a fund's name as gospel. For instance, just because a fund has "tax-managed" as part of its name, that's not a guarantee that it will be. And even though a fund says in its prospectus that it tries to limit investors' exposure to income and capital gains, that doesn't mean it always can. 

Two major catalysts that can lead to increased selling and subsequent distributions are shareholder redemptions and manager turnover (a new manager or comanager will often remake a fund's portfolio to his or her liking).

Take Eaton Vance Tax-Managed Global Small Cap Fund , for instance. You can see that there are large gaps between the fund's pretax and tax-adjusted returns.

What happened here? As the firm explains, Eaton Vance Tax-Managed Global Small-Cap underwent a management transition in 2015 as the firm revamped its global equity investment team, which caused the fund's turnover to spike to 124% that year; from 2009-14 it had been in the range of 48% to 72%. When the fund sold appreciated securities, it led the fund to pay our a large distribution to shareholders that year. All told, the fund's three-, five-, and 10-year tax cost ratios are 3.24, 2.66, and 1.60, respectively.

Eaton Vance portfolio manager Mike Allison, who runs the firm's  Tax-Managed Global Dividend Income  and  Eaton Vance Tax-Managed Growth strategies, said, however, that the Global Small-Cap fund has stabilized and its manager is again focusing on maximizing investors' aftertax returns. 

Are Tax-Managed Funds Worth It?

Tax-managed funds don't guarantee tax efficiency, but many employ tactics that can allow investors to maximize their aftertax return. If you're an investor in a taxable account, take time to investigate and understand the tax-managed strategy, and make some reasonable inferences about whether the fund could successfully mitigate the tax drag even in the worst of circumstances, such as when faced with big outflows or a management overhaul. 

One helpful data point is the fund's potential capital gains exposure. Whereas tax-adjusted returns and tax-cost ratios look at how tax efficient a fund has been in the past, a fund's PCGE helps you gauge how big a tax bill you could possibly face in the future.

But the key word here is "possibly." If the fund doesn't sell the appreciated securities, the gain will not be realized during the calendar year--or anytime soon, for that matter. Funds with low-turnover strategies such as those that follow an index-tracking strategy are less likely to experience events that trigger high turnover (though they are not immune from them).

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Karen Wallace does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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