These Funds Offer You a Break on Taxes

We fund investors get the short end of the stick on taxes. Buy a stock and you don't owe taxes until you sell it for a profit. Buy a fund and you could pay taxes long before you sell it. However, one benefit of last year's losses is that funds now have big losses on their books that largely negate that disadvantage.

Many funds have negative capital gains exposure of more than 50%. That means that they would have to appreciate about 50% before they start distributing capital gains. (Technically, it varies based on flows and how tax-savvy the managers are.) Thus, for a change, someone starting out a fund portfolio today has a major advantage over someone beginning a stock portfolio.

Today, most stock funds in the Morningstar 500 have negative potential capital gains exposure of between 10% and 50%, but there are some good ones with even more. The highest of all is  Fidelity Select Electronics (FSELX), with a negative PCGE of 509%.

There are so many good funds that I'll touch briefly on a bunch that jump out.

 Harbor International Growth (HIIGX) has one of the biggest negative PCGEs (-113%) because performance was weak under previous management. Last year wasn't great for Jim Gendelman of subadvisor Marsico, but his track record is strong, and I like managers who seek out companies that can still grow (or shrink more slowly) in a global recession.

 Oakmark International Small Cap (OAKEX) (-146%) is a deep value gem. You've got to get in funds like this when the style is out of favor. It will be a bumpy ride, so consider buying a starting position today and building up more over the next couple of years.

 T. Rowe Price Global Stock (PRGSX) (-28%) is a small fund with a great manager. Rob Gensler did a great job at the funds that he ran before taking this one over, and I like giving him free rein to invest around the globe.

 Vanguard Explorer (VEXPX) (-78%) isn't the most exciting small-cap fund, but it has superlow costs and strong managers. The fund has consistently beaten its peers and benchmark.

 Vanguard Tax-Managed Growth & Income (-52%) is an excellent large-cap index fund that has never paid capital gains distributions. Given its negative capital gains exposure, it should be quite easy to keep its strong record on taxes.

 Harbor Capital Appreciation (HACAX) (-63%) is a strong, straightforward large-cap growth fund run by Sig Segalas and a solid team from Jennison Associates. This fund has great long-term return potential.

 Artio International Equity II (JETAX) (-75%) is a compelling choice from Richard Pell and Rudolph Riad-Younes, who produced great results at  Artio International Equity I (BJBIX). If you have a dud foreign fund, here's a good opportunity to upgrade.

 Masters' Select Smaller Companies  (-162%) was launched in 2003, and performance has been mixed, leaving it with triple-digit negative gains. But look at its lineup: Bob Rodriguez, Bill D'Alonzo, and Dick Weiss, among others. There's plenty of reason for optimism.

 Longleaf Partners (LLPFX) runs very low turnover, so with 78% negative capital gains exposure I'd have to think that it will be a long time before cap gains are paid out. Yes, last year was dreadful. Cyclical stocks in the portfolio got crushed by the recession. But you're buying Longleaf for management's stock-picking abilities, not its economic-projection prowess. The fund's long-term record is outstanding, and you'd be hard-pressed to find managers with a greater commitment to shareholders. 

This article originally appeared in the February Issue of Morningstar FundInvestor.

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