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Many Happier (Tax) Returns

Use our Premium Fund Selector to make April 15 a little less painful.

All mutual funds are required by law to distribute capital gains and dividends to shareholders annually, and, appropriately enough, this "gift" of income typically occurs around the holidays. Frequently, however, it's accompanied by a lump of coal: Even if you choose to reinvest the proceeds back into the fund, the distribution you receive is subject to taxation if held in a taxable account. Uncle Sam duns long-term capital gains at a 20% rate, while short-term gains (i.e., gains realized on stocks held less than a year) and dividends are taxed as ordinary income.

In 2002, however, only the lucky few will have to worry much about paying taxes on realized mutual fund gains. Nearly all domestic-equity funds, for instance, are looking a lot like Santa Claus lately--they're deep in the red. True, funds sometimes pay out capital-gains distributions in years they've lost money. In 2000, for example, many aggressive-growth fund shareholders took it on the chin from both Uncle Sam and the market when their funds' managers took profits on stocks they'd held during the runup of the late '90s.

That's likely to be less of an issue in 2002, however. At the end of October, the average domestic-equity fund had potential capital-gains exposure of -48% of assets, meaning the typical fund is carrying a substantial loss on its books. Moreover, mutual fund managers are allowed to hoard their losses for later use. These "tax-loss carryforwards" can be used to offset gains made elsewhere in the fund for up to seven years after the loss occurred.

Still, it's never too late to plan ahead.

On the assumption that the market won't remain in a loss-incurring funk forever, this week's  Premium Fund Selector screen will help you whittle down the vast universe of potential domestic-equity core holdings to just those offerings whose managers have proved especially nimble at doing the tax-time waltz with Uncle Sam. Here's the criteria we'll use to cut the rug (and the tax bill) with them:

       (Fund Category = Domestic Stock (ex-specialty))
and (Role in Portfolio = Core)
and (Distinct Portfolio Only = Yes)
and (Morningstar Rating >= Four Stars)
and (5 Yr AfterTax Return (no sale) >= Category average)
and (5 Yr Tax Cost Ratio < Category average)
and (Fund Manager Tenure > Category average)
and (Expense Ratio < Category average)
and (Closed to New Investment = No)

Regular readers of these columns will notice some familiar criteria here. As analyst Paul Herbert mentioned in his article about using the selector to find all-weather funds, screening out pricey offerings, relatively inexperienced management teams, and closed funds will be useful for just about any search you'd want to run. And the "Distinct Portfolio Only" criterion ensures that your search won't return multiple share classes of the same fund.

But other criteria are specific to our tax-efficiency scavenger hunt. As its name suggests, for instance, the AfterTax-Return screen eliminates those funds whose returns have been below their respective average rivals' on an aftertax basis--in this case, over a trailing five-year period.

The Morningstar Tax Cost Ratio is a relatively new data point that gives investors a yardstick for gauging how effective managers have been at minimizing the tax consequences of their transactions. Simply put, over the trailing five years, shareholders in the funds that pass the screen above have lost less of their assets to Uncle Sam than those who invested in the funds' average peers.

Click here to run the search yourself. You'll see that just 42 funds are miserly enough with the tax man to make it through the screen. To research them further, just click on the fund's name and begin perusing its Quicktake page.

After all, only your additional homework will allow you to decide which--if any--of these funds is right for you. Thanks to the Premium Fund Selector, though, you've now got a star-studded short list of funds that may make April 15th at least a little less painful.