Four Great Funds for 401(k)s and IRAs Only

It's been over a year since I wrote about good funds for IRAs, so I thought I'd revisit the subject from a different angle. The basic idea of choosing a fund for a tax-deferred account is to find a great long-term investment. Whether it's tax efficient or not doesn't matter; just find a good one you can hold on to. Last year, I picked a few IRA funds that met that criteria but I didn't go out of the way to pick funds that were not efficient from a tax standpoint.

This time I'll turn around and pick a few outstanding funds that are for tax-sheltered accounts only. This will give you ideas for tax-sheltered accounts, including IRAs, 401(k)s, and 403(b)s, and it will provide an idea of what not to put in a taxable account.

 Artisan International (ARTIX)
This fund won't always be a poor choice for a taxable account, but right now it's sitting on potential capital gains of 35% of assets. Like many good foreign funds, this one has enjoyed stellar returns over the past several years and that means big gains have built up. The fund has returned an annualized 22% over the past three years. With a turnover rate of just more than 50%, it's fair to assume this fund has some taxable capital gains distributions coming up. This applies to a lot of foreign funds, so tread carefully when investing for a taxable account.

As to why you should own it, manager Mark Yockey has built a very long and very appealing track record at this fund and at previous funds. He takes a flexible approach to finding companies set for a growth spurt. As befits a foreign large-blend fund, you'll see a wide array of value and growth stocks in the portfolio.

 Schneider Value 
This is an outstanding fund that still flies below the radar. Arnie Schneider is an outstanding manager who left Wellington's institutional side to start his own firm. Because institutional investors' tax structure is very different from individual investors', Schneider developed his strategy without much regard to taxes. Thus, he runs a turnover of about 75% a year--fairly high for a value manager. Schneider's style is to find supercheap companies that are due for a rebound. He likes to hunt for signs that an industry is in distress and then see if there are some strong companies that can survive the carnage. He's strict about his valuation discipline and will only pay steep discounts to his estimate of value, and he'll sell when valuations return to historic norms. This 5-star fund charges just 0.85% and has only $100 million in assets. (I've been telling Morningstar FundInvestor subscribers about this one since last fall, so you can't say I haven't been doing my part.) It's not available in no-transaction-fee platforms, but you can buy it for a fee through Vanguard's supermarket.

 ICAP International (ICEUX)
This fund combines elements of both of the above two mutual funds. It has built up gains due to a big rally overseas and its value-oriented management team that mostly runs institutional accounts. This great fund clocks in with turnover of 139%--so you definitely want to reserve it for a tax-sheltered account. It's also worth noting that the clock is ticking for no-load investors who are looking to buy into this fund. ICAP sold itself to NY Life and will likely switch the funds to a load structure soon.

Rob Lyon, Jerry Senser, and Matt Pickering, Morningstar's International-Stock Managers of the Year for 2005, blend top-down analysis with a value-investing approach to find attractively priced foreign stocks. Their approach isn't as deep value as Schneider's, though. For example, they're still holding on to a number of energy stocks whereas Schneider sold his on valuation concerns a while ago.

 USAA Aggressive Growth (USAUX)
One theme I heard at our annual investing conference last month was that high-quality large-cap companies looked like great bargains. If so, the funds Tom Marsico runs ought to be well-positioned for the rest of the decade. Marsico has built a great record over 17 years by employing a theme-driven strategy to invest in large-cap growth stocks. Attention to valuations and an eye for big shifts in the economy have helped Marsico make the most of the great growth themes while still avoiding the worst of the sell-offs. It does have fairly high turnover that runs higher than 70%, however, so I'd rather have this fund in a tax-sheltered account. I picked this fund over the ones that bear Marsico's name because it's a little cheaper.

And One to Watch...
 PIMCO Fundamental IndexPLUS Total Return  
This fund is an unusual wrinkle on equity index funds. It marries a proven bond strategy with a brand new index. PIMCO has taken a strategy of trying to outperform the LIBOR bond rate that index futures and swap prices are geared toward and then grafted that strategy onto a number of indexes. The way it works is that the fund buys index swaps--whereby it pays a fee plus LIBOR in exchange for the total return of an index. Because the swaps have a LIBOR rate built into them, PIMCO tries to earn that plus more by investing in bonds (the bond portion is a near-clone to PIMCO Total Return) that it believes will beat LIBOR. If it succeeds in doing that, then the fund will outperform its index before expenses and taxes. In this case, the first hurdle is 1.14%--a high hurdle indeed. In the second case, you don't want to try it in a taxable account. Essentially all of this fund's gains from its swaps and bonds come in the form of income, so it would be a disaster to own it in a taxable account.

The second element here is that this particular fund tracks a brand new index--the Research Affiliates Fundamental Index 1000. The RAFI 1000 weights companies according to their sales, book values, cash flows, and dividends, while most other indexes rely on a company's market cap. The premise is that this approach is superior to that used by market-cap-weighted index funds, which are forced to chase ever-more-expensive stocks. (That can lead to a momentum effect in really powerful growth rallies like the one in 1999.) The downside is that this fund's fundamental index approach will mean greater turnover and therefore greater transaction costs.

I have faith in PIMCO's ability to beat LIBOR but it will be a challenge for PIMCO and this index to make up the expense hurdle on cheap S&P 500 funds. If you want to invest in the RAFI in a taxable account, consider some of the new ETFs based on it, which won't suffer from PIMCO's tax-inefficient overlay. Of course, plain old low-cost index funds are also great for tax-sheltered accounts even though they are tax-efficient.