You may have heard the true story about a young professional baseball player who on the day before income tax returns were due, discovered he had an enormous tax bill. He had invested over $6 million into a group of no-load mutual funds. Everything seemed fine until all of the funds, which included a very well-known index fund, made unanticipated taxable distributions. The athlete had no idea that taxes were due on mutual fund distributions since he, personally, had not redeemed any shares. Needless to say, he was very upset when $400,000 of his investment had to be liquidated to pay taxes. He fired his advisor.

As you know, tax-efficient investment management for high-net-worth clients is not simple. Many an advisor who has recommended low turnover mutual funds or a long-term investment strategy (tactics that are typically associated with tax efficiency) may still get blindsided. Nothing is more maddening to an investor than receiving notice of large capital gains distributions that he was not expecting or even worse, was not aware could occur.

A recent SEC mandate now requires mutual funds to disclose after-tax performance in prospectuses. This may or may not help. SEC “required disclosures” are sometimes confusing, limited in scope, or missing germane information.

Today’s fund managers sit squarely on the horns of a dilemma: Attempting to provide competitive pre-tax returns on one side, while managing a fund’s tax efficiency for taxable accounts on the other. Some believe the two goals are pitted against each other, making it difficult for both to coexist within the same portfolio. Some manage money as if tax efficiency is the ultimate goal; others as if tax efficiency does not matter at all. Butbefore you toss up your hands like fund managers who neglectfully opt to ignore the tax consequences of their portfolio moves, and choose only to concentrate on stock selection and portfolio construction, read on.

When I became an equity analyst for a large institution with over $50 billion invested in equities, a central focus of our investment strategy was to minimize taxable distributions, a valid aspiration. The fund pursued a buy-and-hold strategy resulting in less than a five percent turnover ratio every year and a tax efficiency ratio of more than 90%. While on the surface those ratios looked stellar, what was not apparent to the casual observer was that unrealized capital gains accounted for about 70% of assets under management.

Because of an unyielding adherence to the buy-and-hold philosophy, many of the largest positions in the portfolio were stocks that had been purchased as long as 25 years ago with a cost basis of pennies on the dollar. The fund was handcuffed into a position where it was forced to hold these stocks forever, almost regardless of company fundamentals, valuation, or increased risk associated with significantly overweight positions in tired stocks. If it ever broke from this long-held strategy and sold any of the low-cost shares, the tax-paying owner of the portfolio would have a huge capital gains tax to pay. That taught me that a tax efficiency strategy based solely upon low turnover may not be optimal over the long term.

Many advisors invest time hunting through data looking for funds with low turnover. According to Morningstar, however, some low turnover portfolios (those with an average holding period of three years or more) have produced tax efficiency ratios below 50% over the past five years, an extremely poor record for a widely accepted tax efficiency strategy. In fact, the average tax efficiency ratio of low-turnover equity funds (including index funds) has been fairly mediocre, averaging less than 75% over the last three years. This is not much different than the average ratio of almost 70% produced by all domestic equity mutual funds over this period.

Meanwhile, a fund managed for tax efficiency may produce rates better than 90%, resulting in very meaningful differences in after-tax total returns to fund investors over the long term. Consider that taxes are often the largest cost of owning a mutual fund, reducing average annual returns by about 2.75% over each of the last five years.

Additionally, of low-turnover portfolios with five year records, about 40% have unrealized capital gains accounting for more than 25% of each portfolio, with some exceeding 75% of the portfolio. As you are aware, unrealized gains potentially mean future tax liabilities for your clients. It is this accumulation of embedded unrealized capital gains that allows low turnover portfolios to generate high tax efficiency in the short run, but not necessarily in the long run.

As the professional baseball player found out, you could have an extremely tax-efficient fund for many years in a row; but in the blink of an eye, the manager sells something with a large embedded gain and negates any tax efficiency that was generated over the previous years. It is then up to you as the advisor to explain why to your clients.

The following table compares the Vanguard 500 Index Fund to domestic equity funds (ex-specialty funds) that produced the highest after-tax returns, while maintaining a tax-efficiency ratio of 90% or better over the last three- and five-year periods, and keeping embedded capital gains to 25% or less of the portfolio.

Only four of these ten top-performing funds produced a turnover ratio that indicates an average holding period of more than three years. On the other end of the spectrum, the highest turnover fund of the group indicates an average holding period of about 13 months. For good reason, high turnover has been viewed with skepticism by certain mutual fund investors in most market environments. Some funds have turnover ratios of 150%, 200%, or higher. These extremely high-churn funds have not proven relevant to this discussion of tax-efficient investing.

However, as shown in the table on the following page, funds that do have “medium” turnover can be very tax efficient, if managed to be tax efficient and current with today’s best investment ideas. These results might be a sign that using a low turnover rate as a proxy for tax efficiency may be misleading when evaluating a mutual fund’s potential for generating attractive after-tax total returns.

Choosing a Tax-Efficient Manager

An advisor should do some due diligence and research to find out how fund managers think and act. Rather than simply focusing on the aggregate level of turnover, which may be a misleading indicator of tax efficiency, it is more important to understand the nature of the turnover, as well as the level of unrealized capital gains in the fund. These may ultimately be the determining factors in a fund’s long-term tax efficiency ratio.

Look for managers who are generating both good turnover and bad turnover. Good turnover attempts to offset capital gains with capital losses, and attempts to control risk presented by highly appreciated stocks. Bad turnover is generally considered to be any change in the portfolio that generates unnecessary taxable capital gains, somewhat of an unavoidable byproduct of most active investment strategies. A tax-sensitive fund manager will try to minimize the effects of bad turnover, however, by actively seeking to generate good turnover. For that very reason, this particular manager will not specifically attempt to maintain a low turnover rate.

In 1998, the turnover ratio of the Thornburg Value Fund approached 100%, which is fairly high for a value fund. Some advisors looked at the fund’s favorable pre-tax performance and discounted it for having a high turnover ratio. What some failed to consider was that bad turnover accounted for only about half of that activity, implying a core turnover rate of about 50% and a 24-month average holding period. Good turnover accounted for the remaining activity, resulting in zero capital gain distributions for the year.

Subject to controlling risk caused by concentrated positions in appreciated stocks, the Thornburg Value Fund does prefer to let winners run as long as possible. We believe that a longer-term outlook in picking investments is preferable to a short-term focus. However, as you are aware, taking short-term capital losses produces greater tax benefits than does taking long-term losses. Just as important, but less understood, is that a fund manager may also improve pre-tax returns by actively seeking to realize short-term losses. As such, all high-net-worth clients may benefit from good turnover, whether in taxable accounts or not.

Seeking to generate good turnover forces a fund manager to reevaluate the initial investment thesis on a stock that has unrealized losses. Rather than let the tax event drive the process, each decision to either continue owning the stock or to sell the stock should be a conscious selection based on investment merit. Each decision is similar to the process of evaluating a stock for initial purchase, weighing the estimated risks and rewards of each opportunity. If the manager recognizes that his previous assumptions were too optimistic, he may take the loss rather than hold a long-term loser. If the investment premise for owning a holding is still intact and the valuation remains attractive, however, the stock should not be sold, unless it can be replaced in the portfolio with the stock of a company with very similar fundamentals.

Thus, continually reassessing stocks that have declined in value, while weighing the benefits of good turnover, may force a fund manager to recognize when he is wrong sooner rather than later. This may help to minimize the downside of an investment when a company’s fundamentals are deteriorating or not meeting expectations, counteracting an investor’s natural tendency to retrench and defend an initial decision.

Summing Up

Tax efficiency is not a comprehensive substitute for competitive investment returns, and low turnover does not necessarily equate with high tax efficiency. Advisors should not be misled by statistics and marketing hype from fund companies. Achieving high tax efficiency is no accident and requires diligent management of assets. Check things out yourself. Look for a fund manager whose goal is to generate competitive total returns . . . before and after taxes. The best tax-efficient managers should use a sustainable strategy of realizing taxable gains when necessary, offsetting those taxable gains with capital losses.