Manage Your Taxable Dollars with Style

In the past two weeks, we've emphasized the importance of examining a fund's tax situation when evaluating prospective funds for your portfolio. In Three Funds That Tax-Fearing Investors Can Love, we provided pointers on how to identify funds that are potentially attractive for taxable accounts. In the following column, Three Tax Traps, we highlighted ways to avoid funds that aren't compelling from a tax perspective. This week, we're going to come full circle by evaluating the nine different domestic style box categories, with the aim of helping you further refine your search.

As such, we calculated both the average potential capital gains exposure and the asset-weighted potential capital gains exposure for the nine categories. The average is just that--an average of all the funds in the category--while the asset-weighted number weighs funds based on their assets. Thus, larger funds have a greater impact on the asset-weighted figures.

Here's how the data through July 31, 2005, break down:

Potential Capital Gains Exposure by Category
	Potential Capital Gains Exposure
Category	Asset-Weighted	Average	# of funds
Large Growth	-10.56	-40.60	1,298
Mid-Cap Growth	-18.16	-28.36	743
Small Growth	13.76	-10.21	644
Large Blend	13.93	0.26	1,415
Mid-Cap Blend	21.54	11.59	370
Small Blend	27.09	18.64	453
Large Value	19.07	10.19	1,028
Mid-Cap Value	20.76	16.30	253
Small Value	24.33	21.02	275
Data as of July 31, 2005.

As you can see, the average potential capital gains is typically much higher than the asset-weighted potential capital gains exposure. There's a good reason for this. Tax-loss carryforwards apply a fund's loss to a future year. Therefore, poor-performing funds generally have the biggest tax-loss carryforwards, and, because of their poor records, smaller asset bases. That means those funds that racked up the biggest losses in the bear market aren't counting as much in the asset-weighted averages. Those that performed best, meanwhile, are weighted more heavily as they've either lost less or preserved capital and tended to keep assets from flowing out. In fact, many truly huge funds tend to be managed relatively more conservatively.

As the table reveals, value and small-cap funds (with the exception of small-growth) tend to have larger potential capital gains carryforwards, while growth and large-cap funds (large-value excepted) tend to have smaller carryforwards. Given what has happened in the market over the past five years--small caps have thrived while large caps have struggled, and value funds have easily outpaced their growth peers--this makes sense. It's no surprise, then, that in our column about three potential investments for a taxable account, we picked funds from the large-cap realm.

Indeed, the data suggest that investors who are now reallocating money in their taxable accounts would do well to think twice before putting new money in smaller-cap value or blend funds. Not only do we think that those funds are less compelling from a valuation standpoint, but their potential tax noose is daunting. In contrast, the opposite is true of larger-cap blend and growth funds.

Meanwhile, those who invest in both funds and separate accounts face an interesting choice. That's because a separate account, unlike a mutual fund, is created specifically for the purposes of one person or entity--it's not a pool of money like a fund. Thus, when a new account is created, it comes without the baggage of any taxable gains, even if it's essentially mimicking a public mutual fund, as separate accounts often are. Still, this means that separate accounts may be the better choice for taxable investors considering small caps--particularly small-cap value. Conversely, because a new separate account also would lack any tax-loss carryforwards, investors who are thinking about a new large-cap investment--particularly on the growth side--would likely be giving up a nice opportunity to defer gains if they chose a separate account over a fund.

This analysis can also be applied to other areas of the market and to our different categories. For instance, we know that tech funds are likely still working off sizable losses from the 2000 to 2002 span, while real estate funds appear fattened with capital gains exposure that stems from their gains of the past few years. And while such information doesn't have to make or break your investment decision, paying attention to it--and factors such as whether a fund's manager is focused on pretax or aftertax returns--will likely leave you feeling better on April 15.