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5 Great Active Equity Funds for Taxable Accounts

A variety of strategies can operate tax-efficiently.

A sometimes overlooked aspect of long-term investing is the impact of taxes. Just as high fees can eat away at an investor's portfolio, so too can hefty tax bills caused by income and capital gains distributions.

When it comes to equity funds, there are a handful of things to consider. All things being equal, a fund that pays higher income and capital gains distributions will tend to produce a greater tax liability than one with lower distributions. Funds with a higher portfolio turnover tend to be less tax-efficient because they trade more frequently and are more likely to sell stocks that have appreciated, resulting in realized capital gains. Funds that invest in stocks with high dividend yields tend to pay out more cash to shareholders, resulting in a higher taxable income.

Morningstar offers a variety of data points to help investors assess these risks. Using a fund's reported portfolio turnover and Morningstar's calculated trailing 12-month yield and five-year tax-cost ratio (which measures how much a fund's annualized return is reduced by taxes), a search of Morningstar’s database can be made to identify funds that have been and are likely to remain the most tax-efficient. Below is a selection of five equity funds carrying Morningstar Analyst Ratings of Gold or Silver that rank near the top of their respective Morningstar Medalist peers on these metrics.

Polen Growth POLIX

This Silver-rated fund leverages a patient, concentrated approach that ranks among the most tax-friendly options around. Managers Daniel Davidowitz and Brandon Ladoff lead this highly successful strategy, which leverages insights from an 11-person research staff tasked with covering large-cap growth stocks across the globe. They've produced great returns over the years using a consistent recipe focusing on industry-leading and financially strong businesses. The team trades infrequently, resulting in limited realized capital gains distributions, and its focus on fast-growing firms with heavier reinvestment opportunities naturally produces a portfolio light on dividends. According to Morningstar data, it hasn't paid an income distribution since 2016. Its five-year tax-cost ratio is among the lowest of any medalist equity fund.

T. Rowe Price Dividend Growth PRDGX

A mandate to buy dividend-paying stocks doesn't preclude this Silver-rated large-blend fund from ranking well in terms of tax efficiency. That's because of its low-turnover approach and focus on dividend growth as opposed to yield. Manager Tom Huber targets dividend-growth rates of about 2.0-2.5 percentage points higher than that of the S&P 500, yet those payouts don't represent a higher yield than the index since the underlying businesses grow at an above-average rate as well. Indeed, its trailing 12-month yield as of January 2022 was just 0.81%, lower than the S&P 500's roughly 1.30% yield. Huber invests for the long term and keeps turnover low. He has delivered strong results over his long tenure, which began in 2000. His success stems from a focus on owning large-cap companies that can defend their profits from competition and generate free cash flow, giving them the flexibility to increase their dividend payouts to shareholders.

Oakmark OAKMX

While value-oriented strategies tend to produce higher income levels because their investment universe includes yield-heavy sectors such as financials, energy, and utilities, there are still ones that can be relatively tax-efficient. Manager Bill Nygren of Gold-rated Oakmark has piloted the flexible strategy since 2000, amassing a stellar track record behind a patient approach. The fund outperformed the S&P 500 prospectus benchmark by nearly 4 percentage points from March 2000 through January 2022. Though he currently owns large stakes in financials and energy stocks, Nygren includes a number of non-dividend-paying companies, such as Netflix NFLX and Workday WDAY, which reduces the yield paid out to investors. He also opportunistically captures tax losses to net against realized gains when appropriate to lower investors' tax liability. Nygren hangs on to his positions for years, resulting in low turnover and capital gains distributions, (which tend to be of the more tax-friendly, long-term variety). The fund's January 2022 five-year tax-cost ratio landed in the lowest fourth of medalist equity funds and was below that of its average large-value Morningstar Category peer.

Harding Loevner Institutional Emerging Markets HLMEX

This Silver-rated fund's five-year tax-cost ratio was less than half that of the average diversified emerging-markets medalist. Its two co-lead managers don't trade much, typically posting annual turnover of 25% or less. Fewer trades lead to lighter capital gains distributions, and in recent years, no distributions at all: This version of the strategy hasn't paid out capital gains in the past 10 years. To be sure, the relatively weak performance of emerging-markets equities explains some of this, but the patient approach also factors in. This quality-growth strategy offers a healthy mix of upside potential and downside protection. While it is concentrated in well-known blue chips such as Taiwan Semiconductor TSM and Samsung Electronics, the strategy remains differentiated with meaningful stakes in Mexican firms and no exposure to basic-materials stocks, which are more prominent in its rivals' portfolios.

American Funds Smallcap World SMCWX

This multimanager offering receives an Analyst Rating of Silver because of its analytical firepower in the less-trafficked small- and mid-cap international market. Its team operates tax-efficiently because it keeps a long-term mindset. Turnover typically falls around 30% per year, below the world small/mid-stock category average of roughly 50%. Small-cap companies typically have greater investment needs than large-cap counterparts and tend to pay lower dividends, if at all. The fund has not made an income distribution since 2016. While performance has been volatile, it has delivered excess returns to make up for that over the long run.

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