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Tax-Managed Funds That Don't Sacrifice Returns

These funds look better after taxes than a lot of funds before taxes.

Karen Wallace, 03/27/2002

<P>As April 15 approaches, taxes are probably figuring prominently in your nightmares. Your dreams may be sweeter, however, if you own funds with aftertax returns that best their category's average pretax return. </P> <P>These funds would employ investing strategies that minimize Uncle Sam's claim on returns without compromising performance. (We often hear from fund managers that they don't pay attention to taxes because doing so would harm the fund's pretax returns--and thus, hurt performance for investors in tax-advantaged accounts.)</P> <P>To find these winners, we screened Morningstar's database for tax-managed funds with aftertax returns that beat the average pretax return of the typical fund in their respective categories over the five-year period ended Feb. 28. These are funds whose shareholders haven't had to sacrifice performance for the sake of tax sensitivity.</P> <P> <TABLE cellSpacing="0" cellPadding="0" width=422 border="0" > <TD vAlign="bottom" align="left" bgColor="#999999" colSpan=4><FONT face="Trebuchet MS, Arial, Helvetica" color="#ffffff" size="-2" ><B> No Tax-Managed Burden Here</B></FONT></TD> <TD vAlign="bottom" align=right><IMG height=5 src="http://publish.morningstar.com/im/dot_clear.gif" width=222></TD> <TD vAlign="bottom" align=right><IMG height="1" src="http://publish.morningstar.com/im/dot_clear.gif" width=80></TD> <TD vAlign="bottom" align=right><IMG height="1" src="http://publish.morningstar.com/im/dot_clear.gif" width=60></TD> <TD vAlign="bottom" align=right><IMG height="1" src="http://publish.morningstar.com/im/dot_clear.gif" width=60></TD> <TD vAlign="top" align=right> <DIV align="left" ><FONT face="Trebuchet MS, Arial, Helvetica" color=#999999 size="-2" ></FONT></DIV></TD> <TD vAlign="top" align=right> <P align="left" ><FONT face="Trebuchet MS, Arial, Helvetica" color=#999999 size="-2" ><B>Category</B></FONT></P></TD> <TD vAlign="top" align=right><FONT face="Trebuchet MS, Arial, Helvetica" color=#999999 size="-2" ><B>5-Year<BR>Aftertax<BR>Return*<BR>( % )</B></FONT></TD> <TD vAlign="top" align=right> <P><FONT face="Trebuchet MS, Arial, Helvetica" color=#999999 size="-2" ><B>Category<BR>Avg 5-Year<BR></B></FONT><FONT face="Trebuchet MS, Arial, Helvetica" color=#999999 size="-2" ><B>Pretax<BR>Return<BR>( % )</B></FONT></P></TD> <TD vAlign="top" align=right colSpan=4><IMG height=5 src="http://publish.morningstar.com/im/dot_clear.gif" width=422></TD> <TD vAlign="top" align="left" ><FONT face="Trebuchet MS, Arial, Helvetica" size="-2" >Muhlenkamp <A href="http://quote.morningstar.com/switch.html?ticker=MUHLX" >MUHLX</A> </FONT></TD> <TD vAlign="top" align=right> <DIV align="left" ><FONT face="Trebuchet MS, Arial, Helvetica" color=#000000 size="-2" >Mid-Cap Value</FONT></DIV></TD> <TD vAlign="top" align=right><FONT face="Trebuchet MS, Arial, Helvetica" color=#000000 size="-2" >13.58</FONT></TD> <TD vAlign="top" align=right><FONT face="Trebuchet MS, Arial, Helvetica" size="-2" >10.97</FONT></TD> <TD vAlign="top" align="left" colSpan=4><IMG height=3 src="http://publish.morningstar.com/im/422x9rule.gif" width=422></TD> <TD vAlign="top" align="left" ><FONT face="Trebuchet MS, Arial, Helvetica" size="-2" >Standish Small Cap Tax-Sensitive <A href="http://quote.morningstar.com/switch.html?ticker=SDCEX" >SDCEX</A></FONT></TD> <TD vAlign="top" align=right> <DIV align="left" ><FONT face="Trebuchet MS, Arial, Helvetica" color=#000000 size="-2" >Small Growth</FONT></DIV></TD> <TD vAlign="top" align=right><FONT face="Trebuchet MS, Arial, Helvetica" color=#000000 size="-2" >10.20</FONT></TD> <TD vAlign="top" align=right><FONT face="Trebuchet MS, Arial, Helvetica" size="-2" >7.69</FONT></TD> <TD vAlign="top" align="left" colSpan=4><IMG height=3 src="http://publish.morningstar.com/im/422x9rule.gif" width=422></TD> <TD vAlign="top" align="left" ><FONT face="Trebuchet MS, Arial, Helvetica" color=#000000 size="-2" >Exeter Tax Managed A <A href="http://quote.morningstar.com/switch.html?ticker=EXTAX" >EXTAX</A></FONT></TD> <TD vAlign="top" align=right> <DIV align="left" ><FONT face="Trebuchet MS, Arial, Helvetica" color=#000000 size="-2" >Large Blend</FONT></DIV></TD> <TD vAlign="top" align=right><FONT face="Trebuchet MS, Arial, Helvetica" color=#000000 size="-2" >11.11</FONT></TD> <TD vAlign="top" align=right><FONT face="Trebuchet MS, Arial, Helvetica" size="-2" >6.87</FONT></TD> <TD vAlign="top" align=right colSpan=4><IMG height=3 src="http://publish.morningstar.com/im/dot_clear.gif" width=422></TD> <TD vAlign="top" align="left" ><FONT face="Trebuchet MS, Arial, Helvetica" size="-2" >Eaton Vance Tax-Mgd Growth 1.1 A <A href="http://quote.morningstar.com/switch.html?ticker=ETTGX" >ETTGX</A></FONT></TD> <TD vAlign="top" align=right> <DIV align="left" ><FONT face="Trebuchet MS, Arial, Helvetica" color=#000000 size="-2" >Large Blend</FONT></DIV></TD> <TD vAlign="top" align=right><FONT face="Trebuchet MS, Arial, Helvetica" color=#000000 size="-2" >10.45</FONT></TD> <TD vAlign="top" align=right><FONT face="Trebuchet MS, Arial, Helvetica" size="-2" >6.87</FONT></TD> <TD vAlign="top" align=right colSpan=4><IMG height=3 src="http://publish.morningstar.com/im/dot_clear.gif" width=422></TD> <TD vAlign="top" align="left" ><FONT face="Trebuchet MS, Arial, Helvetica" color=#000000 size="-2" >Eaton Vance Tax-Mgd Growth 1.0 <A href="http://quote.morningstar.com/switch.html?ticker=CAPEX" >CAPEX</A></FONT></TD> <TD vAlign="top" align=right> <DIV align="left" ><FONT face="Trebuchet MS, Arial, Helvetica" color=#000000 size="-2" >Large Blend</FONT></DIV></TD> <TD vAlign="top" align=right><FONT face="Trebuchet MS, Arial, Helvetica" color=#000000 size="-2" >9.34</FONT></TD> <TD vAlign="top" align=right><FONT face="Trebuchet MS, Arial, Helvetica" size="-2" >6.87</FONT></TD> <TD vAlign="top" align=right colSpan=4><IMG height=3 src="http://publish.morningstar.com/im/dot_clear.gif" width=422></TD> <TD vAlign="top" align="left" ><FONT face="Trebuchet MS, Arial, Helvetica" color=#000000 size="-2" >JP Morgan Tax Aware U.S. Equity Sel <A href="http://quote.morningstar.com/switch.html?ticker=JPTAX" >JPTAX</A></FONT></TD> <TD vAlign="top" align=right> <DIV align="left" ><FONT face="Trebuchet MS, Arial, Helvetica" color=#000000 size="-2" >Large Blend</FONT></DIV></TD> <TD vAlign="top" align=right><FONT face="Trebuchet MS, Arial, Helvetica" color=#000000 size="-2" >8.34</FONT></TD> <TD vAlign="top" align=right><FONT face="Trebuchet MS, Arial, Helvetica" size="-2" >6.87</FONT></TD> <TD vAlign="top" align=right colSpan=4><IMG height=3 src="http://publish.morningstar.com/im/dot_clear.gif" width=422></TD> <TD vAlign="top" align="left" ><FONT face="Trebuchet MS, Arial, Helvetica" size="-2" >Frank Russell Tax-Managed Large Cap S <A href="http://quote.morningstar.com/switch.html?ticker=RETSX" >RETSX</A></FONT></TD> <TD vAlign="top" align=right> <DIV align="left" ><FONT face="Trebuchet MS, Arial, Helvetica" color=#000000 size="-2" >Large Blend</FONT></DIV></TD> <TD vAlign="top" align=right><FONT face="Trebuchet MS, Arial, Helvetica" color=#000000 size="-2" >8.13</FONT></TD> <TD vAlign="top" align=right><FONT face="Trebuchet MS, Arial, Helvetica" size="-2" >6.87</FONT></TD> <TD vAlign="top" align=right colSpan=4><IMG height=3 src="http://publish.morningstar.com/im/dot_clear.gif" width=422></TD> <TD vAlign="top" align="left" ><FONT face="Trebuchet MS, Arial, Helvetica" size="-2" >Schwab 1000 Inv <A href="http://quote.morningstar.com/switch.html?ticker=SNXFX" >SNXFX</A></FONT></TD> <TD vAlign="top" align=right> <DIV align="left" ><FONT face="Trebuchet MS, Arial, Helvetica" color=#000000 size="-2" >Large Blend</FONT></DIV></TD> <TD vAlign="top" align=right><FONT face="Trebuchet MS, Arial, Helvetica" color=#000000 size="-2" >8.00</FONT></TD> <TD vAlign="top" align=right><FONT face="Trebuchet MS, Arial, Helvetica" size="-2" >6.87</FONT></TD> <TD vAlign="top" align=right colSpan=4><IMG height=3 src="http://publish.morningstar.com/im/dot_clear.gif" width=422></TD> <TD vAlign="top" align="left" ><FONT face="Trebuchet MS, Arial, Helvetica" size="-2" >Vanguard Tax-Managed Grth & Inc <A href="http://quote.morningstar.com/switch.html?ticker=VTGIX" >VTGIX</A></FONT></TD> <TD vAlign="top" align=right> <DIV align="left" ><FONT face="Trebuchet MS, Arial, Helvetica" color=#000000 size="-2" >Large Blend</FONT></DIV></TD> <TD vAlign="top" align=right><FONT face="Trebuchet MS, Arial, Helvetica" color=#000000 size="-2" >7.97</FONT></TD> <TD vAlign="top" align=right><FONT face="Trebuchet MS, Arial, Helvetica" size="-2" >6.87</FONT></TD> <TD vAlign="top" align="left" colSpan=4><IMG height=3 src="http://publish.morningstar.com/im/422x9rule.gif" width=422></TD> <TD vAlign="top" align="left" ><FONT face="Trebuchet MS, Arial, Helvetica" size="-2" >Vanguard Tax-Managed Balanced <A href="http://quote.morningstar.com/switch.html?ticker=VTMFX" >VTMFX</A></FONT></TD> <TD vAlign="top" align=right> <DIV align="left" ><FONT face="Trebuchet MS, Arial, Helvetica" color=#000000 size="-2" >Domestic Hybrid</FONT></DIV></TD> <TD vAlign="top" align=right><FONT face="Trebuchet MS, Arial, Helvetica" color=#000000 size="-2" >6.98</FONT></TD> <TD vAlign="top" align=right><FONT face="Trebuchet MS, Arial, Helvetica" size="-2" >6.07</FONT></TD> <TD vAlign="top" align="left" colSpan=4><IMG height=3 src="http://publish.morningstar.com/im/422x9rule.gif" width=422></TD> <TD vAlign="top" align="left" ><FONT face="Trebuchet MS, Arial, Helvetica" size="-2" >Vanguard Tax-Managed Capital App <A href="http://quote.morningstar.com/switch.html?ticker=VMCAX" >VMCAX</A></FONT></TD> <TD vAlign="top" align=right> <DIV align="left" ><FONT face="Trebuchet MS, Arial, Helvetica" color=#000000 size="-2" >Large Growth</FONT></DIV></TD> <TD vAlign="top" align=right><FONT face="Trebuchet MS, Arial, Helvetica" color=#000000 size="-2" >8.33</FONT></TD> <TD vAlign="top" align=right><FONT face="Trebuchet MS, Arial, Helvetica" size="-2" >6.06</FONT></TD> <TD vAlign="top" align="left" colSpan=4><IMG height=9 src="http://publish.morningstar.com/im/422x9rule.gif" width=422></TD> <TD vAlign="bottom" align="left" colSpan=4> <P><FONT face="Trebuchet MS, Arial, Helvetica" color=#999999 size="-2" >Data through 2-28-02.<BR></FONT><FONT face="Trebuchet MS, Arial, Helvetica" color=#999999 size="-2" >*Takes into account only capital-gains distributions and income, not sale of fund.</FONT></P></TD></TABLE></P> <P> <P>All of the funds on our list start with category-beating pretax returns. Since they also tended to be far more tax-efficient than their average peers, these funds' results look good before and after the tax man cometh.</P> <P>One of the funds on the list--Ron Muhlenkamp's  Muhlenkamp Fund <?XML:NAMESPACE PREFIX = MSTR /?><MSTR:SECURITY>MUHLX</MSTR:SECURITY>--does not call itself a tax-managed fund in its prospectus, but tax sensitivity is so ingrained in Muhlenkamp's style that Morningstar includes it in its tax-managed fund group.</P> <P>Muhlenkamp's ability to merge prescient macroeconomic calls with solid stock-picking has kept his fund in the top 20% of his category on a pretax basis over the trailing three- and five-year periods. Combine that performance with a history of keeping more than 96% of its returns after taxes, and you have a fund whose tax-adjusted returns beat the average (pretax) returns of the mid-cap value category by 2.6 percentage points over the last five years ending February 28. </P> <P>Standish Small Cap Tax-Sensitive's <MSTR:SECURITY>SDCEX</MSTR:SECURITY> aftertax returns also look good compared with the pretax returns of its category over the five-year period: It has kept more than 81% of its returns during that time. The fund, however, had a hard time living up to its name in 2000, namely because of two enormous capital-gains distributions totaling $17.88, or roughly 28% of the fund's net asset value, in the wake of former manager Nicholas Battelle's departure. Although $17.88 is a huge capital-gains distribution for any fund--much less a fund that purports to be "tax-sensitive"--Morningstar fund analyst Alan Papier says the move made sense.</P> <P>"After racking up big returns in 1999, the fund sold some of its better-performing holdings to raise cash to meet redemptions, and to make sure those who chose to exit the fund upon Battelle's departure would be held accountable for their fair share of the tax liability," said Papier.</P> <P>The fund also faltered in 2001, with a 21.7% loss that landed it in the category's bottom quarter. Papier believes the current management team is moving in the right direction. Management combines an earnings-growth-driven strategy with an element of tax management. Specifically, it tracks its holdings by lot, which enables it to sell its lowest tax-cost shares with each transaction, said Papier. </P> <P>In contrast,  Eaton Vance Tax Managed Growth 1.1 <MSTR:SECURITY>ETTGX</MSTR:SECURITY> has never made a capital-gains distribution over its seven-year lifetime. The only tax-inefficient blemish on the fund's otherwise sterling record is one $0.05 income distribution in 1997. Manager Duncan Richardson favors modestly priced stocks that are growing earnings by 10% or more and holds them for at least five years. The low turnover and Richardson's skill at selling losers to offset the taxable gains of his winners have helped this fund, notes Morningstar fund analyst Christopher Davis. It has held on to almost 100% of its returns over the past five years.</P> <P> JP Morgan Tax Aware U.S. Equity <MSTR:SECURITY>JPTAX</MSTR:SECURITY> has also avoided capital-gains distributions. Managers Terry Banet and Louise Sclafani draw on the recommendations of JP Morgan analysts, who recommend stocks that look attractive based on cash-flow projections. Management strives to keep taxes to a bare minimum; for example, capital gains are offset with losses, and shareholder redemptions of more than $250,000 are met with stocks, says Morningstar fund analyst Shannon Zimmerman. Smart stock-picking and a focus on tax management have made this a solid core offering that looks good both before and after taxes, Zimmerman says. The fund has kept almost 98% of its returns over the trailing five-year period.</P> <P>Index funds, which buy and hold stocks in their benchmark indexes, are inherently more tax-efficient than most mutual funds, but some index funds are more tax-efficient than other passive offerings. Charles Schwab <MSTR:SECURITY>SCH</MSTR:SECURITY> often touts the tax efficiency of its index of large companies, the  Schwab 1000 <MSTR:SECURITY>SNXFX</MSTR:SECURITY>, and with good reason; the fund has kept almost 96% of its returns safe from taxes over the trailing five-year period. Although investors can find cheaper large-blend index funds, this offering's broad diversification and tax efficiency still make it a good choice, says Morningstar fund analyst Dan Culloton in a recent analysis.</P> <P>Three of the funds that met our tax efficiency criteria are managed by Vanguard's indexing guru Gus Sauter. Sauter limits taxes at  Vanguard Tax-Managed Growth & Income <MSTR:SECURITY>VTGIX</MSTR:SECURITY> by selling high-cost shares first and recognizing losses to offset gains. This has enabled the fund to keep more than 94% of its returns over the last five years.</P> <P>The stock portion of  Vanguard Tax-Managed Balanced <MSTR:SECURITY>VTMFX</MSTR:SECURITY>, a domestic-hybrid offering, mimics the Russell 1000 index while avoiding high-dividend-paying stocks in the index, says Morningstar fund analyst William Harding. While that bias may cause the fund to miss out a bit when cheap stocks with high dividend yields rally, as in 2000 and 2001, it limits the fund's tax liability, because income received from dividends is taxed at the normally higher, ordinary income rate, Harding says. Also, Sauter limits taxes by investing in municipal bonds, which pay out tax-exempt income. The fund has kept more than 88% of its returns over the five-year period.</P> <P>At  Vanguard Tax-Managed Capital Appreciation <MSTR:SECURITY>VMCAX</MSTR:SECURITY>, Sauter uses a computer-driven sampling technique to track the Russell 1000 and zero in on the lowest-yielding stocks in the index. Consequently, the fund has kept nearly all of its returns over the trailing five-year period and has reaped tax-adjusted gains that slightly edged the pretax average returns of its peers during that time.</P> <P>Neither Tax-Managed Capital Appreciation, Tax-Managed Balanced, nor Vanguard Tax-Managed Growth & Income have made capital-gains distributions in their lifetimes, notes Harding.</P>

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