Don't let these funds trip you up on taxes.
This article originally appeared in Morningstar FundInvestor, an award-winning newsletter that presents investment strategies and tracks 500 funds.
Red Flags is designed to alert you to funds' hidden risks. Such risks can take many forms, including asset bloat, the departure of a solid manager, or a focus on an overhyped asset class. Not every fund featured is a sell, and in fact some are good long-term holdings. But investors should be prepared for a potentially bumpier ride in the near future.
Clients can take steps now to minimize their tax bill by avoiding holding the wrong fund in a taxable account. Certain categories of funds are best suited for tax-deferred accounts. For example, high-yield funds throw off lots of interest income that is taxed at higher rates. Similarly, REIT dividends don't qualify for the lower dividend tax rates, making REIT funds more appropriate for your 401(k) or IRAs.
Watch out for high turnover stock funds and certain specialized strategies that, while successful, aren't particularly tax-friendly. This month, we point out a few funds that are likely to throw off lots of taxable gains or income and would be best held in a tax-sheltered account.
Bill D'Alonzo and the team from Friess Associates, advisor to these funds, employ a research-intensive strategy that has produced impressive long-term results. Management looks for rapidly growing firms trading at reasonable prices but is quick to dump stocks when growth slows or it gets a better idea. So, turnover at both funds runs well into the triple digits. That increases the likelihood of realizing capital gains.
Lately, the funds have been able to avoid capital gains distributions because during the bear market they built up stores of capital losses they used to offset capital gains. But it appears that those capital-loss carryforwards have been exhausted, and we think the likelihood of capital gains distributions has increased. Granted, these funds have been competitive on a tax-adjusted basis, but they look much better from a pretax perspective. For example, Brandywine's 10-year trailing pretax returns are almost 2 percentage points better than the aftertax result.
American Century Value
This all-cap value fund also employs a quick-trading strategy that impairs its tax efficiency. Managers Phil Davidson, Scott Moore, and Michael Liss adhere to a strict value discipline, and they are quick to sell stocks that appreciate beyond their price targets. As a result, turnover here is well above the typical large-value offering, and that's had tax implications for shareholders. The fund has made capital gains distributions in all but two of the last 10 years, and its 10-year tax-cost ratio (a measure that expresses taxes in the same form as an expense ratio) of 2.92% is one of the highest in the large-value category.
This fund's distinctive approach doesn't lend itself to tax efficiency. Managers Fred Green and Bonnie Smith buy the stock of acquisition targets and often short the stocks of the acquirer. The pair are experienced hands at this strategy (known as merger-arbitrage), and they've produced remarkably steady results. The fund posted negative returns in only one calendar year since its 1989 inception. Plus, it has very little correlation with the broader market, which makes it a potent diversifier. However, tax efficiency isn't its strong suit. It has distributed capital gains in eight of the last 10 calendar years, and taxes have taken a sizable bite out of long-term returns. Its 10-year tax-adjusted returns fall more than 2 percentage points shy of its pretax results.
Calamos Market Neutral
It's a similar story for this fund. It employs an unusual strategy that isn't particularly tax friendly. The fund is run by John Calamos Sr. and son John Calamos Jr., who are both experts on convertible securities. At this offering, the pair invest in convertible bonds and then short the underlying stocks, an approach that's produced consistent returns and a healthy yield. But the fund has also distributed sizable interest and capital gains distributions in every year of its existence that have taken a toll on its tax-adjusted performance. Over the past decade, it has returned more than 8% per year on average, but after Uncle Sam takes his share, that return shrinks to just more than 5%.
Sonya Morris is an analyst with Morningstar.