Tax-managed funds pique investor interest

Tomorrow is the deadline for filing income taxes, but investors are already thinking about ways to pay less next year — driving more to consider tax-managed mutual funds.

If it looks as if taxes are going up, the advantage of tax-managed funds will increase, said Chuck Neff, wealth manager with Balasa Dinverno & Foltz LLC of Itasca, Ill., which manages $1.5 billion in assets.

“Some are holding shares of highly appreciated stocks because they don’t want to sell and have to pay taxes,” he said. “If they think the tax rate is going to go up, they may lighten up on those positions and pay the tax this year.”

Tax-managed funds use strategies to reduce distributions and exposure to capital gains.

Assets in such funds totaled $63.3 billion at the end of February, a 58.2% increase from $40 billion in 2004, according to Lipper Inc., a New York-based fund research firm.

Investors can also accomplish tax efficiency through annuities or by putting more money into a 401(k), some say.

“I don’t like to make a decision based on taxes,” said Ivory Johnson, director of financial planning at Scarborough Capital Management Inc. of Annapolis, Md., which manages $1 billion in assets. “I am looking for steady, risk-adjusted returns over time. Tax-managed funds don’t distribute as many capital gains, but don’t chase that over performance.”

More clients are looking ahead.

“People believe that if the Democrats win, they will raise taxes,” Mr. Johnson said. “This will increase the demand for [tax-managed accounts], but that doesn’t necessarily make it prudent.”

Others agree.

“[Clients] are really watching what is going on with the election,” Mr. Neff said.

His firm focuses on tax efficiency through tax-loss harvesting; optimal allocation,which often involves allocating the least-tax-efficient investments to tax-deferred ac-counts; and using tax-managed vehicles.

DISTRIBUTIONS

Tax-managed funds are not the way to go, said Tim Maurer, director of financial planning at The Financial Consulate Inc., a 24-year-old Baltimore firm that does not disclose its assets under management.

“We don’t want to make investment decisions based only on tax reasons,” he said. “Especially in the current market, with all the volatility, the last thing I want a money manager thinking is that we should just hold on for tax reasons.”

Clients are looking ahead, and now is the time for strategy, Mr. Maurer said.

Investors were not as concerned about capital gains from 2003 to 2006, when losses from the bear market were carried forward, said Tom Roseen, a senior re-search analyst at Lipper.

But the offsets ran out.

“This should be a banner year for tax-managed products,” Mr. Roseen said, estimating that long- and short-term income distributions could hit a record $33.8 billion.

In a report that Lipper will release tomorrow, capital gains distributions are expected to total a record $581 billion in 2007, up nearly 39% from a previous record of $418 billion in 2006.

The election and higher taxes will probably drive flows into tax-managed funds, said Duncan Richardson, executive vice president and chief equity investment officer at Eaton Vance Corp. of Boston, which has $10.2 billion in assets in 10 open-end tax-managed offerings.

“Even with these relatively low tax rates now, people are losing money,” he said. “Wait till they get a load of what they’ll lose with higher rates. In the interim, people are going to be taking advantage of these tax-managed accounts.”

The typical actively managed equity fund may not have as many options to manage taxes, said Scott Donaldson, senior investment analyst at The Vanguard Group Inc. of Malvern, Pa., which has more than $12 billion in assets in five tax-managed funds.

Strategies in these funds involve locking in a loss, not realizing a gain or keeping stocks that don’t pay high dividends, he said. “Actively managed funds are designed to lock in gains,” Mr. Donaldson said.

Investors on average have been paying from 1.4% to 2.3% in taxes on returns that they could have earned each year for the past 10 years, Mr. Roseen said.

E-mail Sue Asci at [email protected].