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TAX-MANAGED FUNDS
Tax-smart money management trends

There's a common saying within the investment industry that says, "Don't let the 'tax tail' wag the 'investment dog'". In short, don't let tax issues be the dominant factor in the investment decision-making process. However, there is a trend in the US mutual fund industry that is nicely blending tax awareness into the larger investment selection process. It's called "tax-managed" investing and its popularity is quickly growing among savvy investors with larger portfolios. Is it a trend that we might catch from out southern neighbours?

THE NEED FOR, AND TREND TOWARD, TAX AWARENESS

While many monthly mutual fund publications and on-line data services publish rates of return, that's only half of the story for investors with money outside of RRSPs, RRIFs, and other tax-deferred savings plans. For money invested in taxable accounts, published returns are important, but more important are the returns investors can expect after tax implications are considered for individual tax rates. There simply isn't any source that publishes after-tax returns that are dependable and practical.

Some might question the sustainability of this trend in an era of government budget surpluses and falling income tax rates. However, if we consider that the more mature US mutual fund industry is usually about five to seven years ahead of the Canadian industry, we may well see mandatory after-tax return disclosure. The SEC has tabled legislation that would require mutual funds in the US to publish both pre-tax and after-tax returns on all funds. According to this article from IndexFunds.com the rule proposes to present after-tax returns in the prospectus in two ways:

  • after paying taxes on fund distributions; and
  • after paying taxes on fund distributions and the sale of fund units.

    Why the new rule? Lack of investor awareness is the key since only about 1/3 of investors participating in a survey said they were knowledgeable on tax issues as they relate to investing.

    Further, AIMR (the global governing body of money managers and the association which licenses the CFA designation) requires the disclosure of after-tax returns in its Performance Presentation Standards (AIMR-PPS -http://www.aimr.org/standards/pps/pps.html ). Though AIMR's PPS are voluntary standards, those wishing to claim compliance with the standards must publish after-tax returns for taxable accounts.

    TAX-MANAGED INVESTING EXPLAINED

    Tax-managed investing is simply a way of managing money that is sensitive to taxable investors, without making tax concerns the number one priority. It's mainly practised in stock portfolios and, very simply, involves two key characteristics:

  • maintaining a buy-and-hold philosophy (i.e. low turnover); and
  • selling "losers" to generate losses to offset any realized capital gains.

    Recall that a portfolio's turnover rate refers to its trading frequency. The more often a fund trades (i.e. higher turnover), the more likely it is to realize capital gains, which must be paid out (and taxed in the hands of) fund unitholders.

    BAD TURNOVER vs. GOOD TURNOVER

    Bad turnover, from the taxable investor's viewpoint, is frequent trading that generates taxable income (i.e. capital gains distributions). While distributing taxable income means that the fund has made money (a good thing), it also means taxes must be paid sooner rather than later (bad). The timing and frequency of taxable income is what can significantly impact an investor's after-tax rate of return. A study done by Jeffrey and Arnott on the tax implications of turnover found that most of the "tax damage" is done once a fund's turnover exceeds 20 per cent. That is true in theory and doesn't necessarily hold in all actual cases. However, it's a true general reflection of the tax impact of turnover.

    Good turnover, on the other hand, is that which reduces taxable income or takes advantage of tax provisions used to shelter realized gains. This means year-end tax selling to prevent fund unitholders from paying taxes on capital gains made from selling winners. Also, there are provisions of our tax laws (CGRM - capital gains refunding mechanism) that allow funds to keep some of its realized gains without paying them out to unitholders - an after-tax return enhancer.

    Tax-managed investing is based on a balance of giving the manager the flexibility to sell (and realize gains on) stocks whose valuations have reached uncomfortable levels and offsetting those gains with selling just enough losing stocks to prevent unitholders from receiving taxable distributions.

    HOW TO INCORPORATE THIS STYLE INTO PORTFOLIOS

    While there may still be a place for high turnover funds, like those practising a momentum philosophy or those focussing on small caps or specific sectors, these are often ill suited to taxable portfolios. Holding high turnover funds in tax deferred savings plans and low turnover (or tax-managed) funds in taxable accounts are fundamental to building tax-smart portfolios.

    While it's important to remember the saying that began this article, properly incorporating tax-awareness into portfolios can significantly enhance bottom line returns. This is the first in a series of three articles on tax-managed funds. Part II in this series will focus on ways to recognize a "tax-smart" money manager, and concluding the series with profiles of a few Canadian funds that are run with the same concept as US tax-managed funds.

    Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
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    Disclaimers: Consult with a qualified investment adviser before trading. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, financial advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. More...