Evaluating tax-managed equity funds: Perspective matters

January 2, 2014 Categories: Portfolio Corner
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Evaluating tax managed equity funds: perspective matters

We have written in the past on this blog about the need for advisors to focus on after-tax returns for taxable accounts. In that context, we’ve talked about some of the criteria to consider in trying to evaluate after-tax returns. For instance:

  • Is the fund designed to be tax-efficient?
  • What is the capital loss carry-forward situation?
  • How material is the undistributed capital gain within the fund?

Advisors will often listen to this and come back with:  “Your points about tax-efficiency make sense, but when I look at two funds – my current fund and a fund that is designed to be tax efficient — my current fund has a similar or better after-tax return over the last 5 years. Why would I change?”

That is definitely a fair question. Allow me to try an analogy to help make the point on evaluating tax-efficient choices.

Suppose you are about to drive across the Mojave Desert in August. It’s a 450 mile journey with no gas stations or rest stops. For this drive, you are given the following choice of cars:

Tax managed chart

Which car do you select? Based on the facts as presented, you may be indifferent to which car you select since they both achieved the same miles per gallon / distance on a tank of gas. Most of us would likely pick Car A – comfort is good.

Before you head off, what if I told you that on the prior trip – when both cars recorded 45 mpg and traveled 450 miles – the entire trip had been downhill AND had a 45 mph tailwind

Knowing this, you would likely revise your decision about which car to take. You may now prefer the car that is explicitly designed to go further on a gallon of gas. After all, the possibility of being stuck on the side of the road in the Mojave Desert short of your goal is not attractive.

How does this relate to the selection of tax-managed equity funds? Looking at the after-tax returns of mutual funds over the last 5 years, many have benefited from similar tailwinds:

The bottom line

As we move into the New Year and you are evaluating tax-efficient investment options for your clients, make sure you understand how each fund’s after-tax return was achieved. Does the mutual fund prospectus explicitly mention tax-aware investing? Has the mutual fund used up its capital loss carry-forward? Is the after-tax return by design or incidental? Understanding this may help your clients achieve their financial goals and not be caught short on the side of the road.

RFS 11956-b

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  1. January 3rd, 2014 at 10:02 | #1

    Important considerations for investors! This will be a big conversation this year as taxpayers start preparing their 2013 returns.

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