These High-Quality Equity Funds Work Better in a Tax-Sheltered Account

A blockbuster season for mutual fund capital gains distributions in late 2014--an outgrowth of the long-running bull market--underscored the importance of asset location: paying attention to what investment types go in which account types.

Investments that give shareholders a high level of control over capital gains realization--individual stocks, exchange-traded funds, and tax-managed funds--are a good fit for taxable accounts. With such investments, the taxes the investor pays are aligned with his or her own profits, rather than with the fund's own trading and distribution schedule.

Meanwhile, investments that dish out substantial income and capital gains distributions on a year-to-year basis aren't to be dismissed out of hand, but they are better off held inside the confines of a tax-sheltered account. That way, investors won't owe taxes on those income and capital gain distributions as they go; investors in Roth accounts will never have to pay the piper, and investors in tax-deferred (Traditional IRA and 401(k)) accounts will only owe taxes when they begin taking money out of their accounts in retirement.

To help shine a light on the latter fund type--high-quality funds that are better placed inside of a tax-sheltered wrapper like an IRA or 401(k)--we screened for medalist equity funds with top-quartile five-year returns as well as five-year tax-cost ratios of 1% or more. Tax-cost ratios aim to depict the percentage drag from taxes that an investor in the highest tax bracket would have experienced over a given time period.

Coming out of the bear market, many stock funds had large tax-loss carryforwards on their books that they were able to use to offset gains in the early innings of the recovery; tax-cost ratios, by and large, looked pretty benign. But many such offerings burned through those tax losses as the bull market wore on, and they've looked decidedly less tax-friendly more recently.

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to see some of the funds that showed up on our screen for high-quality funds that have had high tax-cost ratios and may, therefore, be a better fit for a tax-sheltered account. Note that we screened out funds that are closed to new investors, but some of the funds with the highest tax-cost ratios are, in fact, closed. Being closed tends to magnify the impact of taxable capital gains payouts, as assets can leave the fund but they can't get back in, so capital gains distributions are frequently spread across a smaller shareholder base.

Here's a look at three of the funds that made the list.

Category: Small Blend | Analyst Rating: Bronze | 5-Year Tax-Cost Ratio: 2.01

Although this micro-cap fund had historically been quite tax-efficient, employing an indexlike strategy and aiming to offset capital gains with losses elsewhere in the portfolio, it made

. As a result, its near-term tax-cost ratio statistics are substantially higher than its long-term numbers. The fund's spike in capital gains distributions owes to the soaring performance of micro-cap stocks during the market's resurgence. (The fund gained 51% in 2013 alone.) Although management doesn't automatically trade out of companies that grow beyond the tiny-cap range, many of its highly appreciated holdings no doubt outgrew its micro-cap focus. Still, senior analyst Greg Carlson lauds the fact that the fund provides access to a corner of the market that can be difficult to access and notes that parent company Bridgeway has "done virtually everything right from a stewardship standpoint."

Category: Large Blend | Analyst Rating: Bronze | 5-Year Tax-Cost Ratio: 1.09

While large-cap index funds are generally pretty tax-friendly owing to their low turnover, this fund has pushed out bigger capital gains distributions than other funds of its ilk over the past few years. Its one-, three-, and five-year tax-cost ratios are now well over 1%. Analyst Mike Rawson believes that shareholder redemptions--perhaps as investors have gravitated toward lower-cost exchange-traded and index-fund alternatives (including in Schwab's own lineup)--have forced management to sell highly appreciated winners that it might have otherwise held on to. The fund still earns a Morningstar Analyst Rating of Bronze, though Rawson would like to see fees come down even further, given the fund's large asset base.

Category: Large Growth | Analyst Rating: Bronze | 5-Year Tax-Cost Ratio: 3.78%

This fund's tax-cost ratio has spiked--it was nearly 4% over the past year--since new manager Dan Martino took over from Joe Milano in 2013. Senior analyst Laura Lallos notes that Martino has made substantive changes since assuming control. Notably, Martino reduced the portfolio's once-outsized exposure to smaller-cap names, many of which had no doubt enjoyed sizable appreciation since their original purchase. Yet, recent tax headaches aside, Lallos points out that the fund is off to a good start under its new manager. Owing to Martino's strong record on a previous charge, his backing by T. Rowe's strong analyst team, and the firm's stellar Parent score, the fund recently received a bump up in its Analyst Rating, from Neutral to Bronze. It's also worth noting that the fund's tax efficiency may improve over time, after Martino has fully remade the fund to his liking.