Use this screen to uncover tax-efficient options for your clients.
While tax time may seem like a distant memory now, it should always be front and center for investors who are building portfolios in their taxable accounts. There are ways, however, to keep the tax man at bay. In the hunt for funds capable of producing strong returns on a tax-adjusted basis, Morningstar Principia and Advisor Workstation can serve as helpful tools for sifting through thousands of options. There are quite a few criteria to include here, so let's start by zeroing in on a fairly specific group: diversified domestic large-cap funds.
Special Criteria = Distinct Portfolios Only
And ( Morningstar Category = Large Growth
Or Morningstar Category = Large Blend
Or Morningstar Category = Large Value )
Next, we turn to the tax-cost ratio. This measure, which Morningstar calculates on a monthly basis using load- and tax-adjusted returns, reflects Uncle Sam's take as a percentage-point reduction in an annualized return. Essentially, this ratio treats the negative effect of taxes on performance in a similar way to other cost measures, in basis points. The tax-cost ratio typically lands between 0% and 5%, where a measure of 0% means that a fund had no taxable distributions and a higher number indicates that a fund has been less tax-efficient. Here, we screened for funds with a 10-year tax-cost ratio of 1.00% or less, which means that on average each year, investors lost up to 1.00% of their total return to taxes.
And Tax Cost Ratio 10 Yr < = 1.00
There is a second major component to the tax-efficiency test, and this one is more forward-looking. Funds generate capital gains distributions when they sell holdings at a gain, and the tax consequences are the greatest for stocks held less than a year, so we wanted to find offerings that don't trade excessively. The fund's turnover ratio indicates how often the manager trades, so a high ratio indicates that there may be more gains from trades that are subject to taxes in any given year. The typical large-growth fund has 97% annual turnover, so the typical manager in that category trades through nearly the entire portfolio each year. Large-blend and -value fund managers tend to trade a bit less--around 60% to 70% annually. Given this, we set this screen for funds with less than 50% annual turnover, which is consistent with an average two-year holding period.
And Turnover Ratio < = 50
And because strong tax efficiency might be the result of tax-loss carryforwards, where the fund can use past losses to offset future gains, we also required that these funds post top-third 10-year category rankings.
And % Rank Category 10 Yr < = 33
We're already worried about taxes eating away at returns, so we don't want hefty expense ratios to make a big dent either. We therefore limited our search to the most reasonably priced funds that are open to new investment by requiring annual expense ratios of 1.00% or less.
And Audited Expense Ratio < = 1.00
And Purchase Constraints not equal to Closed-New Investment
As of Aug. 6, 2008, this screen pulled a mix of roughly 35 options. Keep in mind that this screen can also be run for mid- or small-cap stocks, in addition to subsets of the international stock, taxable bond, muni bond, or balanced categories. We suggest that you modify the criteria for fixed-income funds, though, by eliminating the turnover criteria and setting a lower expense ratio.
Here are some funds that fit the criteria and that Morningstar analysts recommend.
American Funds New Economy ANEFX
Like other offerings from Capital Research, this large-growth fund is run by a team of portfolio managers who manage their slices independently but rely on an expansive and deep central team of analysts. More often than not, these managers are patient with their picks, so turnover has stayed low over time. This fund was launched in the early 1980s with the goal of focusing on service providers, which the firm viewed as becoming a major part of the global economy. Over the years, that has certainly come to fruition as the U.S. economy has indeed become much more focused on services than manufacturing. The fund's focus has skewed its portfolio toward the technology, telecom, media, and financial-services sectors. Sector concen-tration can court risk; however, other aspects of the fund, such as stock diversification, attention to price multiples, and sizable cash stakes have helped keep a lid on volatility. With regard to performance, the fund's 10-year annualized aftertax return of 2.96% through Aug. 6 has beaten roughly 70% of its peers. So, even though the fund is not explicitly dubbed "tax-managed," the low-turnover approach has certainly kept a lid on taxes.
Davis New York Venture NYVTX
Another example of tax efficiency is found here. Thanks to the patience of managers Chris Davis and Ken Feinberg, this fund's turnover hasn't gone above 10% over the past five years. The Davis team is always on the lookout for battered stocks, conducting its own earnings analysis to get a picture of a firm's cash flows and eventually gauging how efficiently the company has allocated capital in the past. Davis and Feinberg positioned the fund well toward the tail end of the last bear market (2000-2002), and they've found plenty of opportunities during this year's market downturn. Indeed, Davis and Feinberg have shown a knack for picking well-managed franchises that deliver over the long haul. This fund's 4.13% 10-year annualized tax-adjusted return through Aug. 6 beats out most large-blend peers'--the average peer posted 2.52% annualized gains after taxes for the time period.PAGEBREAK
Franklin Rising Dividends FRDPX
Like Davis, this fund's managers also employ a low-turnover approach, but its dividend focus is rather unique. Lead manager Don Taylor, along with other longtime managers Bill Lippman and Margaret McGee, looks for firms that have increased their dividends in eight of the past 10 years and that have also doubled that payout during the same timeframe. In addition, they exclude firms with debt greater than 50% of their market capitalizations. So, these restrictions mean that high-growth names don't make the cut. This approach led to an excellent showing during the bear market of 2000 through 2002--the fund returned a whopping 30% during those years. In recent years, though, the fund has lagged. For one, this fund generally tends to trail its peers in speculative growth rallies, but it also lagged in 2007 because it got caught owning dividend-rich financials when they took a nosedive. An avoidance of energy and utility stocks also damped returns, but things started to change in 2008 as the manager's focus on reasonably priced dividend-payers started to look a lot more attractive. After taxes, long-term shareholders have gained 4.27% annually over the past 10 years through Aug. 6, which is better than more than 80% of its peers' gains.
Vanguard Tax-Managed Cap. Apprec. VMCAX
As its name implies, this fund is run with the explicit aim of minimizing Uncle Sam's take. Longtime manager Michael Buek runs this large-blend fund using a sampling technique, and the resulting portfolio of stocks has a lot in common with the Russell 1000 Index. That said, Buek favors the lowest-yielding stocks in the index to curb taxable gains, and because the fund has low turnover (5% annually at last count), it has posted attractive aftertax returns for long-term shareholders. Its 3.26% 10-year annualized returns after taxes beat out roughly 75% of its peers'. We'd also point to the fund's ultralow 10-year tax/cost ratio of 0.20. So, over the past 10 years, shareholders in this fund lost about 0.20% of assets annually to taxes, whereas the typical large-blend fund has given up 1.01% annually.
Karin Anderson is a fund analyst with Morningstar.