Funds That Should Keep the Taxman at Bay

Are there still equity funds out there that are positioned to be tax-efficient for years to come? It's been two years since the end of stocks' steep decline, in which many funds wound up with steep realized losses on the books. And stocks have since doubled in value, which ought to have erased a good chunk of those losses as the funds sold their winners. Furthermore, any tax-loss carryforwards (which can be used to offset realized gains, thus limiting taxable distributions to shareholders) from the 2000-02 bear market expired by late 2009. (Realized losses can be used to offset gains for seven years.)

Limiting taxable distributions can save investors quite a bit of money over the long haul--much more than they might expect. "Taxes can actually take the biggest bite out of returns, more than management fees or trading costs," says Colleen Jaconetti of Vanguard's Investment Strategy Group in a recent primer on the subject. "Historically, domestic equity funds have lost two percentage points a year to taxes. And the impact of taxes on their total wealth isn't always obvious to investors. They're typically paid at a later date, sometimes out of a different account."

Some Choices Are Battered, But Still Promising
The good news is that despite the market's sharp rise since early 2009, there are a good number of funds with sizable tax-loss carryforwards. Value funds seem to sport bigger ones at this point. While growth funds fared worse in the 2000-02 bear market as tech, media, and telecom imploded, value funds generally posted steeper losses in the most recent bear market as financial firms and debt-heavy fare in general were punished. But many funds of both stripes boast veteran managers and fine long-term records, though they've performed poorly in the most recent bear market. For investors in taxable accounts looking for equity funds, the funds below could be good choices. And some managers aren't shy about promoting the potential tax efficiency of their funds in the near future because of past losses.

 Clipper (CFIMX) has been run by Christopher Davis and Ken Feinberg for five years. True, the fund has struggled mightily over that stretch, but the pair has amassed a superb long-term record at another large-value fund,  Selected American Shares  (SLADX) (which currently has net realized gains). That fund's portfolio is more diversified, but the strategy is similar. In its December 2010 annual report, the managers argue that Clipper is well-positioned from a tax standpoint, as well as in other ways. "There is strong reason to believe this last decade of poor absolute stock returns will lead to much better returns in the years ahead. Furthermore, based on the prospects for and valuations of the companies we own in Clipper Fund, we believe our relative performance should improve as well...Should this happen, the fact the Fund's realized and unrealized losses equal almost 26% of its net asset value will make it highly tax-efficient."

 JHancock Classic Value (PZFVX) is another large-value fund that got hammered in the recent bear market. As a result of its decline and subsequent shareholder redemptions, its tax-loss carryforward was recently slightly larger than its asset base. Lead skipper Richard Pzena's bold approach has led to a lot of volatility, so only investors with strong stomachs need apply. But he's generated fine relative results since the fund's 1996 inception.

 Fidelity Advisor Diversified International (FDVAX) has tax-loss carryforwards equal to 67% of its assets, while the identically managed  Fidelity Diversified International (FDIVX) has roughly 10% of unrealized capital gains exposure. Why the difference? Manager Bill Bower took over the Advisor fund in February 2009--late in the bear market--and thus realized losses on stocks owned by his predecessor as he reshaped the portfolio to his liking. Also, the fund has seen hefty outflows relative to its size, so those losses are spread across a smaller asset base than Diversified International.

 DWS Global Thematic (SCOBX) had a rough 2007-08, and many investors headed for the exits. So, the fund's tax-loss carryforward was recently equal to 43% of its net assets. Furthermore, manager Oliver Kratz has done a fine job here using a theme-based approach since taking the helm in late 2003.