Will Tax Relief Cause These Portfolios Pain?

The Taxpayer Relief Act of 1997 almost certainly will heighten investors’ desire to pay taxes at the new, lower capital gains rates.

But whether the new legislation will boost the appeal of “tax-managed� mutual funds is an open question.

These funds have enjoyed a modest boom in recent years by striving to reduce or eliminate the amounts in dividends and capital gains they pay to investors. Because such distributions are taxable, many investors are not eager to receive them.

The 1997 tax legislation lowered capital gains rates to a maximum 20% levy from 28%, making it less urgent for investors to find shelter in the form of tax-managed mutual funds.

“Relatively speaking, the new tax law is neutral or slightly negative for tax-managed funds,� says Joel Dickson, co-author of a landmark 1993 Stanford University study on tax efficiency and who now works for the Vanguard Group in Valley Forge, Pa.

Simply put, there’s less of a penalty now if you hold “tax-inefficient� funds--those that frequently lock in or realize capital gains, paying out such profits each year to investors.

These distributions will be taxed at the top 20% rate assuming a mutual fund hangs onto its stocks for the minimum 18 months needed to qualify for the lower rates. Otherwise, the gains will be considered short-term and will be subject to ordinary income-tax rates, which means a federal levy that can go as high as 39.6%.

At least a dozen tax-managed funds have taken root in the last several years. Most focus on large U.S. stocks, although a few also mix in holdings of municipal bonds, which pay tax-free interest.

Eaton Vance this year plans to unveil a tax-managed fund geared to foreign stocks, says Tom Faust, stock research director at the Boston firm.

Of course, all tax-managed mutual funds are designed to be held

outside of individual retirement accounts, 401(k)s and other tax-sheltered plans. Because the new tax law enhances the appeal of IRAs, that’s a modest negative for tax-managed funds. But the funds are not subject to the yearly investment limits that apply to these other vehicles. Thus, they make sense for people who are maxing out on their IRA and 401(k) contributions.

Tax-managed funds avoid high-dividend stocks along with corporate or government bonds. As a result, they don’t collect a lot of dividend or interest income that must be paid out to shareholders at higher ordinary-income rates. In addition, they strive to minimize their capital gains payments to investors in the following ways:

* They hang onto profitable stock positions as long as possible so that they don’t realize gains that must be passed along to shareholders.

* When they must sell shares in a profitable stock, they first unload their highest-cost “lots,� or batches of shares, thereby minimizing gains.

* They sell unprofitable investments periodically to lock in capital losses that can be used to cancel out any capital gains.

This third angle sets tax-managed funds apart from index funds, Dickson says. Index funds aim to replicate the performance of a barometer such as the Standard & Poor’s 500 by purchasing the same basket of stocks. They don’t sell shares simply to lock in a loss, since doing so often would affect their ability to do the very thing they are in business to do: replicate the index’s performance.

“Index funds already are very good after-tax performers,� says Dickson. “But tax-managed funds take this one level higher.�

It’s worth noting that both index funds and tax-managed funds could see some of their benefits be diminished if a sharp market decline spurs investors to redeem shares en masse. In such an event, portfolio managers might have to sell some stocks at a profit, thereby triggering capital gains liabilities.

Incidentally, the tendency of tax-managed funds to hang onto profitable stocks may make sense from an investment standpoint too.

“It’s a hold-your-winners, cut-your-losers approach,� says Faust. “It goes against that element of human nature whereby people are too quick to declare victory on their winners.�

But will the new tax act itself boost the appeal of these funds?

Faust says Eaton Vance has enjoyed an uptick in sales for its Tax-Managed Growth fund since the legislation passed. But three other groups with competing funds--Vanguard, Charles Schwab and USAA Investment Management--say they haven’t noticed the same effect.

The Taxpayer Relief Act also attaches new significance to the “turnover rate,� which all mutual funds must list in their prospectuses. This rate measures the amount of buying and selling a portfolio manager does. A 100% turnover rate, for example, implies that a manager replaces each stock once a year on average, whereas, say, a 50% turnover suggests each stock is held for two years on average, and a 200% reading indicates a six-month average holding.

Tax-managed portfolios have very low turnover rates, on average--certainly well below the 75% figure that would imply stocks are being held for 18 months on average, thereby qualifying for the lower long-term capital gains.

Thus, tax-managed funds could look pretty good compared with high-turnover funds that buy and sell more frequently.

“Investment managers generally don’t take the tax consequences of their trading practices into consideration,� says Dickson. “What matters to people investing outside of IRAs and 401(k) plans is not total returns but tax-adjusted returns.�

Here are some of the larger mutual funds that aim to minimize taxable distributions to shareholders:

* Eaton Vance Marathon Tax-Managed Growth, (800) 225-6265

* Evergreen Tax Strategic B, (800) 807-2940

* Schwab 1000, (800) 435-4000

* USAA Growth & Tax Strategy, (800) 382-8722

* Vanguard Tax-Managed Balanced, (800) 662-7447

* Vanguard Tax-Managed Capital Appreciation, (800) 662-7447

* Vanguard Tax-Managed Growth & Income, (800) 662-7447

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Russ Wiles is a mutual funds columnist for The Times. He can be reached at [email protected]