"To maximize after-tax returns, you have to get high pre-tax returns"

Given a choice between overseeing the nation’s biggest and oldest actively run tax-managed mutual fund or cruising the world in the fast-attack nuclear submarine USS Parche, Duncan Richardson would pick the fund job any day.

“I think I have the best job in the industry,” says the 42-year-old manager of the Eaton Vance Tax-Managed Growth Fund. “I’m doing something that fewer and fewer investors are doing, which is taking a long-term perspective. In a submarine you are very day to day — in tense situations you live second by second.”

Mr. Richardson, who as an Annapolis graduate spent five years in subs before joining Eaton Vance in Boston in 1987, has been at the helm of Tax-Managed Growth for nine years. Although not known for knockout performance, the $5.5-billion fund had rewarded long-term investors with a 10-year annualized return of 17.50% through Oct. 31.

Short-term investors may be feeling a little frustrated, however. Thanks in part to relatively big bets on such out-of-favor sectors as financial and health-care stocks, the fund has stumbled. Its 6% return for the year through October pales in comparison to the 16% return for the average large-cap growth fund, according to Morningstar, the Chicago-based fund tracker.

Still, Mr. Richardson is taking it all in stride. He is confident that the tax-managed fund’s performance will rebound, especially as the market broadens out.

“The fact is that it’s a very narrow market,” he says, “more narrow than any we have ever operated in, including the `Nifty Fifty’ days” of 1973-1974 when a relatively few large-caps dominated Wall Street.

Q So, how does a stock get into the fund?

A What we’re looking for is fundamentally good companies that generally will have a short-term cloud of disappointment around them. We’re looking for entry points at which we think stocks can double over a five-year period.

Q Do you buy a position in a company all at once or over a period of time?

A The approach is to patiently accumulate it over weeks or months to build an investment position of 1%. We’re looking for an investment like Home Depot at the ending of 1996 or early 1997.

Q Why do you try to limit your exposure to a particular stock to around 1%?

A My philosophy in running the portfolio is not to take unnecessary risks. I don’t like to take too much stock-specific risk. So, the top holding will typically be only 1?% to 2%.

Q What about computer printer maker Lexmark, at 2?% of the portfolio?

A It’s done so well that it has kind of earned its place there. We originally bought Lexmark three years ago at much lower prices ($12 to $20 a share) and it has tripled in the last year. It’s done a lot of its work for the portfolio already. I don’t want it to become too large a position so I did trim some back.

Q So, how do you decide when to sell a particular stock?

A There’s a very strict sell discipline we use on our mistakes. If I’ve accumulated a stock and it drops down 10% from cost, we are going to sell it.

Q What about the successful side of the sell discipline?

A We’re very patient with our winners, much more focused on mistakes and getting at those early so we preserve capital. But I typically will sell a stock if it’s reached an extraordinary valuation level or if there’s too much stock-specific risk.

Q Why is the portfolio slightly underweighted in technology?

A I think there’s going to be a lot of volatility there over the next two quarters.

Q What’s your outlook for financials, the portfolio’s biggest sector bet?

A That’s certainly hurt us this year. The rising interest rate environment has not been good. What I see fundamentally is that a lot of business and economic statistics got pulled into the third quarter from the fourth and I think we are going to see the slowdown. People are going to worry more about deflation than about inflation.

Q What stocks have come on the radar screen lately?

A The nice thing about all this volatility is that it’s bringing new stuff in every day. We had been taking advantage of some of the weakness in financials to buy BankBoston and the regional phone companies SBC Communications Inc. and Ameritech Corp. and Bell Atlantic, which is merging with GTE. We’ve been big buyers of Sprint in the last couple of quarters. We think those companies are pretty well positioned to compete and as they roll out their digital subscriber line technology to get broadband revenues, they’ll have some success. Right now, valuations suggest that cable has won the game. I’m not so sure about that.

Q What’s going on with the fund’s performance? Year-to-date, you are lagging behind the large-cap growth category.

A We’re disappointed with the year-to-date and one-year numbers. We have deemphasized the mega-cap stocks. The valuation of those stocks (at 40 to 50 times earnings) is not where we think it’s necessary to take that level of risk. We’ve also suffered from the slight overweighting we’ve had in financials, health care and consumer staples. The slightly underweighted areas that we’ve had — cyclicals, basic materials and energy — would have been good places to be overweighted in.

Q Do you invest your own money in your fund?

A I own Eaton Vance stock, and my own funds as well as other Eaton Vance funds.

Q How do you incorporate tax-efficiency into your strategy?

A To maximize after-tax returns, you have to get high pre-tax returns. On the pre-tax side, our goal is to achieve top-quintile performance. After-tax side, our goal is to achieve top-decile performance.

We take losses when we have them, not just at the end of the year. We do tax-lot accounting. We sell our highest-cost stocks first and make sure our holding period is at least a year. We have found that you can pick up 2 percentage points a year if you manage that way. That’s huge. It’s the difference between being in the middle of the pack and being in the top quartile.

Q Is the new competition in tax-efficient funds hurting you?

A Tax-managed funds account for less than 1% of the entire mutual fund industry. There’s lots of room for competition. You can apply this strategy to value investing, if you have a long enough time horizon. We’re actually close to hiring a value manager.

Q What do you think of reporting after-tax returns?

A It’s going to happen because Securities and Exchange Commission Chairman Arthur Levitt Jr. wants it to happen. The industry wants it to happen, too. It’s just a matter of getting consistent standards. We’ll be reporting after-tax returns in our annual reports for our tax-managed funds this year.

There’s a danger in not understanding the difference between tax-efficient and tax-managed funds. Investors might equate historical tax efficiency with tax management.

A fund can be tax efficient, not because the manager pays any attention to it, but because of relative fund inflows. But if the style of the manager was inherently a high-turnover trading strategy, a different market environment would turn what was a very tax-efficient fund into a tax bomb.

Q Isn’t a manager’s job to worry about returns, not shareholders’ taxes?

AThe proof is in the pudding. It depends on whether tax-managed strategies can achieve large pre-tax returns. There’s nothing inherently that cuts back on the pre-tax returns on the types of investment strategies that we use on our funds. What rational investor wouldn’t want to pick up 2 percentage points a year without taking any higher risk?

Vitae

Duncan W. Richardson, 42, Portfolio manager of Tax-Managed Growth and co-portfolio manager of Information Age Fund at Eaton Vance Corp. in Boston

Tax-Managed Growth (assets, $5.5 billion): year-to-date return, 10.42%; 1-year, 21.21%;

3-year, 21.88%

Average large-cap growth fund: ytd, 24.55%; 1-yr, 43.20%; 3-yr, 26.55%

Information Age (assets, $85 million): ytd, 52.88%; 1-yr, 72.89%; 3-yr, 30.05%

Average world stock fund: ytd, 21.28%;

1-yr, 30.70%; 3-yr, 15.28%

Data through Nov. 16 with periods over one year annualized

Source: Morningstar Inc.