Top Contenders Among Tax-Friendly Funds

Holding investments in tax-sheltered accounts relieves investors from having to consider tax-related consequences when they buy and sell. But investors commonly hold mutual funds outside of their retirement accounts with little consideration to the bite that taxes can take out of their returns. That's a mistake because those taxes can really add up. Beyond the taxes incurred on stock dividends and bond interest, mutual fund investors also have to pay taxes when their funds make capital gains distributions or when they sell funds for a profit. Those taxes could quickly chew a hole into returns.

The good news is that it isn't difficult to pay attention to tax efficiency, and doing so is one of the easiest ways to exert a level of control over a portfolio's bottom-line returns.

To help investors unearth tax-friendly mutual funds, we turned to  Morningstar's Premium Fund Screener for some metrics that could help gauge a fund's tax efficiency. We began by focusing on funds across all the investment universes with minimum initial purchase requirements of $5,000 or less. We then homed in on distinct portfolios of offerings for which Morningstar Analyst Reports are available. We applied a screen for funds with tax-cost ratios and potential capital gains exposure that are less than the category average. The tax-cost ratio is a historical measure of how much investors in the highest tax bracket have surrendered, in percentage terms, to the tax collector. Potential capital gains exposure attempts to measure a fund's future tax efficiency by showing you the extent to which a fund's portfolio consists of appreciated securities on which the fund hasn't yet paid taxes. (Note that having a sizable potential capital gains exposure doesn't necessarily mean a fund will be tax-inefficient in the future; funds can maintain sizable potential capital gains exposure figures for many years.)

Because tax-efficient funds are not necessarily the best-performing funds, we filtered for strong performers with Morningstar Ratings for funds of 3 stars or higher that ranked in the top quartile of their peer groups during the past 10 years. In addition to requiring that managers have helmed the fund for at least five years, we eliminated funds with expenses above the category average. Premium members can run the screen by  clicking here.

The screen brought up a list of 11 funds, three of which we highlight below.

 Old Mutual Focused  (OBFVX)
Expense Ratio: 0.95% | Load: None
Manager Jerome Heppelmann balances risk and reward by focusing on domestic large caps with economic moats and the greatest upside potential. Despite the fund's high turnover rate, Morningstar analyst Kathryn Young makes note of the fund's top-ranked aftertax returns during the past five- and 10-year periods. (This indicates that a low turnover rate is not a tell-all measure of tax efficiency.) One caveat is that the fund is highly concentrated, with just 30 to 40 names, which may cause it to lag when one or more of its holdings underperform. But Heppelmann's able management during his 10-plus-year tenure has helped demonstrate that this fund remains an excellent long-term offering.

  Vanguard Global Equity (VHGEX)
Expense Ratio: 0.44% | Load: None
This fund's four managers keep a portfolio of close to 800 names (more than 8 times more than the typical world-stock offering). But its focus on value keeps it distinct from its world-stock peers, which tend to be more blend- and growth-focused. Moreover, its hunt for value has caused this fund to increase its exposure to developed Europe and the developing world while significantly decreasing its exposure to the United States, further separating this offering from its peers. Morningstar analyst William Rocco believes that this fund's contrarian approach gives it a good shot at outperforming its peers, and its low turnover keeps this fund tax-efficient. Moreover, incredibly low expenses, coupled with experienced and qualified managers who employ a sound strategy, give this atypical fund an edge.

 BlackRock Capital Appreciation 
Expense Ratio: 1.13% | Load:5.25%
Comanagers Jeff Lindsey and Ed Dowd are opportunistic investors who seek companies that are already enjoying strong earnings growth, but they don't want to overpay for it. Their track record together is proof that they're skilled stock-pickers--recently, for example, they've been able to find companies with compelling valuations that have been depressed by uncertainty about the economic recovery. Currently, they devote two thirds of the portfolio to stable growth stocks and the rest to atypical growth opportunities, such as  Delta Air Lines (DAL). While these opportunistic stock picks do make for increased volatility, Lindsey and Dowd's strong long-term record during their five-year tenure have proved their skill in navigating uncertain waters with ease.

Data as of Jan. 18, 2011.

We made a correction on this article based on new information received from Old Mutual Focused. The Z-share class is open to new investors.