These Equity Funds Keep Taxes in Check

Regular visitors to Morningstar.com know that Morningstar places great emphasis on cost of ownership when it comes to choosing funds. Funds that charge expense ratios higher than those of their peers lose points in our Analyst Rating methodology and create a handicap that must be overcome if they are to outperform. In fact, Russ Kinnel, Morningstar's director of mutual fund research, has found that expense ratio is a greater predictor than even past performance of a fund's future success.

But the cost of owning a fund isn't paid only to the fund company. Mutual funds also generate tax costs when they pay out dividends and capital gains to their shareholders who hold their funds inside taxable accounts. Even if the investor hasn't sold a share of the fund and has reinvested dividends and capital gains, he or she is still taxed on those distributions. A fund that buys and sells stocks frequently may produce an inordinate amount of capital gains, which ultimately are passed on to shareholders and taxed; short-term capital gains, which occur when a manager sells a security for a gain after holding it for less than a year, are taxed at investors' ordinary income tax rates. Of course, funds also sometimes sell holdings at a loss, which can produce a tax benefit because the loss can be used to offset other gains, or carried forward to offset gains in future years. So a fund's turnover rate in itself isn't necessarily an indicator of tax-efficiency.

Even though many equity-fund investors prize dividends, dividend income also may be adding to shareholders' tax bills when that income is distributed. In this regard funds with lower yields may be said to be more tax-efficient. However, there is a caveat here because fund expenses are paid from income first. A fund with a low yield (and lower taxes as a result) but a high expense ratio is no bargain.

To quantify how much of a fund's total return is lost to taxes, Morningstar computes a tax-cost ratio, which can be found under the Tax tab on each fund's Quote page on Morningstar.com. If a fund returned 10% in a given year but had a 2% tax-cost ratio, that means investors realized just an 8% return after taxes. (Note that tax-cost ratio is calculated based on the experience of investors in the highest tax bracket; for more on this methodology, click here.) But as we've seen, looking at tax-cost ratio alone is not enough. Expenses and funds' aftertax returns must be factored in, as well. A low-cost fund with an identical basket of securities as a high-cost fund may have a higher tax-cost ratio but better aftertax returns. (That said, aftertax returns alone aren't always a good measure of tax efficiency either because a fund that delivers stellar absolute returns but has high tax costs will still look better than one with greater tax efficiency but poor performance.)

Tax sensitivity might be more of an issue for investors in higher tax brackets than those in lower brackets. As a result of the fiscal cliff agreement in Washington, married taxpayers making $450,000 and above ($400,000 for singles) will pay 20% tax rates on dividends and long-term capital gains while those in middle brackets continue to pay 15% and those in the 15% and lower brackets pay nothing. (For more on what's changed for investment-related taxes in 2013, see this article.) 

Then there's the new 3.8% Medicare surtax, which starts on investment income for married taxpayers earning more than $250,000 and single tax filers earning more than $200,000. Of course, those holding funds in tax-deferred accounts such as a 401(k) or IRA avoid having to pay taxes on capital gains and dividends, so they needn't worry about tax costs at all.

While tax considerations should never be your primary driver when investing in an equity fund, Morningstar.com offers a variety of tools to gauge how a fund performs in this regard. In addition to tax-cost ratio and tax-adjusted returns, each fund page's Tax tab includes potential capital gains exposure data to give investors a sense of how much a funds' holdings have appreciated and whether a large capital gains tax bill could be coming.

Ideas for a Smaller Tax Hit
For investors looking for quality stock funds that take a smaller tax bite--perhaps for use in taxable accounts--broad-market stock index funds and exchange-traded funds can be solid choices. The following screen also homes in on some potentially worthwhile ideas. 

We set the  Premium Fund Screener tool to search for equity funds with Morningstar Analyst Ratings of Bronze or better and rock-bottom tax-cost ratios of 0.2% or less on average for the trailing 10-year period. We used this relatively long time frame to weed out funds whose more recent tax-cost ratios may have been helped by the carrying forward of losses from the steep market drop of 2008 and early 2009, which could make some funds look more tax-efficient than they will be in the future. To keep out names whose yields are lowered because of high expense ratios, we limited our list to funds with average or lower expense ratios for their categories. Also, we screened off our list institutional funds, funds closed to new investors, and those charging loads. (In some cases, however, no-load versions of funds on the list might not be available to new investors whereas load versions are.) As always, investors who don't mind paying a load can simply remove this part of the screen for more choices. Premium Members can see the full list  here. Below is a sampling.

 Harbor Capital Appreciation (HCAIX)   
10-Year Tax-Cost Ratio: 0.01    
With its low yield (0.07% for the trailing 12-month period) and slightly below-average turnover (44%) for the category, this large-growth fund doesn't sacrifice much of its return to Uncle Sam. Its tax-cost ratio has remained at 0.03 or lower across all trailing time frames. Manager Sig Segalas, who has run the fund since 1990, looks for companies growing faster than the S&P 500 Index, with solid balance sheets and defensible franchises.  Apple (AAPL) is the largest single holding at about 6% of a portfolio that historically has leaned toward technology and health-care companies. Of course, this heavy exposure to the tech giant has backfired thus far in 2013, with the fund's 1.7% return trailing 94% of its peers as of Feb. 25.

 Vanguard Small Cap Growth Index (VISGX)   
10-Year Tax-Cost Ratio: 0.08    
Because they typically trade less than actively managed funds, index funds have a well-earned reputation as tax-efficient investment vehicles. However, tax costs still can come from dividend income (the current SEC yield for the S&P 500-tracking Vanguard 500 Index (VFINX) fund is 2.03%, for example) and the sale of shares to meet fund redemptions, which can trigger capital gains. This fund, which recently switched to tracking the CRSP U.S. Small Cap Growth Index, has a 12-month trailing yield of 0.84% and a turnover rate of 40%. The new index provider is careful not to move small companies in and out of the index haphazardly, which could help reduce turnover. The fund's 0.24% expense ratio adds to its low cost of ownership.