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TAX-MANAGED FUNDS: PART II
Identifying tax-sensitive funds and managers

Part I of this series of articles discussed the growing US trend of tax-managed funds - funds managed in a more tax-sensitive manner. Though the term "tax-managed" hasn't really penetrated the Canadian mutual fund industry, we certainly have stock funds that are managed in this fashion. But how can investors identify them? That's our focus this week.

MARKETING MATERIAL

The first and easiest place to start, when looking for tax-smart money managers, is the marketing material. Any investment management firm that is serious about taking care of their taxable investors will often state it loudly and clearly through their communications with current and prospective investors. This could include anything from marketing brochures to the firm' s website and annual reports. Though they're not Canada's only tax-sensitive money management firm, AIC Group of Funds is probably the most "vocal" about their funds' tax-awareness.

TURNOVER OR TRADING FREQUENCY

Readers have seen the term "turnover" quite often in this space and just for good measure, I'll remind you that a fund's turnover rate is its trading frequency or the rate at which the portfolio is "flipped" or traded each year. While fund turnover rates had been very difficult to find in the past, times have changed. The new mutual fund simplified prospectus has two basic parts:

  • One part discussing general information about the funds; and
  • Information that is specific to each fund offered under the prospectus.

    In that second part, go to the fund in which you're interested and look for a table entitled "Ratios and Supplemental Data". This table will list information including the fund's management expense ratio (MER) and portfolio turnover rate. Remember that a turnover rate of 100 per cent means that a fund has completely "flipped" its portfolio of stocks exactly once during the year. Ideally, you want five years of turnover data to examine and look at the average and consistency. Turnover rates that consistently run far above 30 per cent per year may be more likely to distribute significant amounts of taxable income over time. Let's take a look at the Trimark Fund (a global stock fund) as an example. Its turnover rate is consistently in and around the 30 per cent mark. Only once in the past five calendar years has turnover exceeded 40 per cent but not by much (43 per cent in 1997). Turnover in this case appears to be low, particularly in comparison to its peers. While that looks good, we'll have to examine whether or not this turnover has been "good" or "bad" (see last week's column for an explanation http://www.stingyinvestor.com/SI/funds/04202001.shtml).

    DISTRIBUTION HISTORY

    Funds that make money and trade frequently are going to realize capital gains. Generally, such gains (or profits from trading) must be paid out (and taxed in the hands of) fund investors. Somewhere near the "Ratios and Supplemental Data" table, you should find a section called "Financial Highlights". In this section, you will find the distributions, if any, that the fund has paid out (per unit) over the past five years and the breakdown of the type of income. Okay, it's a bunch of numbers so what are you supposed to do with that? There are two things to look for here and let's continue with the AIM American Blue Chip Growth fund to illustrate.

    First, each annual distribution per unit won't tell you much on its own but when examined in relation to its year-end unit price or NAVPS (net asset value per share), it can be revealing. Trimark Fund pays out very small distributions in most years - ranging from 1 to 2 per cent of the year end NAVPS. However, in 1997 it paid out a whopping $5.40 per unit, representing nearly 25 per cent of its year end NAVPS of $22.05. While some investors are still hurting from that distribution, this fund does a good job of avoiding significant distributions in most years. Be careful of funds that usually pay distributions but haven't done so for a year or two. Sometimes, they could simply be benefiting from losses of other years (where their stock selling was unprofitable).

    The second thing to look for is the type of income that has been paid out. Most stock funds are expected to pay out mainly capital gains, which is now the type of investment income, which attracts the least amount of taxes (except for those in the lowest tax bracket). Trimark Fund's distributions over the past five years have been more than 93 per cent capital gains.

    LOCATION OF INVESTMENT MANAGER'S HOME AND ASSET BASE

    Suppose you have in front of you three managers: one based in Toronto, one based in London England, and one based in New York. Which one would you expect to be most sensitive to Canadian tax issues? Of course, you would expect the Canadian-based money manager to have a greater awareness of Canadian tax issues. However, there is another influence here. Even foreign money managers would be sensitive to Canadian investors if a substantial portion of the money they manage comes from Canadian investors.

    For instance, Brandes Investment Partners is based in San Diego California but more than 10 per cent of all of the money they manage around the world is in the AGF family of funds. In 1999, the Brandes-managed AGF International Value fund was expecting a significant distribution (about 11 per cent of the NAVPS), but some year-end tax-loss selling trimmed that down to almost nothing. That's a perfect example of a foreign manager who is sensitive to Canadian tax issues and prevented a big tax bill for unitholders.

    TAX EFFICIENCY

    Tax efficiency is a statistic which estimates the retention rate, after-tax, of investment income from mutual funds. Often quoted for one, three and five years periods, a ratio of 100 per cent would indicate that no taxes were payable during the period measured (i.e. pre-tax return = after-tax return). This is available from some data providers as Morningstar Canada and some newspapers. However, the tax efficiency figure has two big weaknesses.

    First, it's based strictly on historical data and makes no attempt to be forward looking. Its second and most significant weakness: it treats interest income and Canadian dividends equally for tax purposes. That's huge since the two receive such different tax treatments, particularly for those in the lower tax bracket. Use this ratio very carefully.

    It's important to remember that investors' primary focus should be on finding a manager or fund that fits well into the overall investment strategy. Tax consideration, though significant, should be a secondary consideration. While the tips above can help in finding tax efficient funds, it's also important to verify that the history you're looking at is relevant (note: see my March 25, 2001 column ).

    Next Week: profiles of some of Canada's best "tax-managed" investment 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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