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SOME OF CANADA'S BEST TAX-MANAGED FUNDS
Ideal funds for your taxable account

In this article, the last in a series of three, some of Canada's most tax-sensitive mutual funds are profiled. While these may not be the only funds run in this fashion, they are some of the best funds in this category. The three funds are Royal Dividend, AIC Advantage, and Mackenzie Universal Future. Each is distinct in its focus and strategy, but all share a common goal: to make money for unitholders without incurring significant tax liabilities.

ROYAL DIVIDEND

John Kellett runs this gem for Royal Bank Investment Management and looks for companies that are financially strong and pay a steadily growing dividend. This, and all, dividend funds have a natural bias towards interest-sensitive stocks (i.e. financial services, utilities, pipelines) that are trading at attractive prices. As is the case with dividend funds, this one is a bit unique. Though it's heavily invested in common stocks, it also typically holds about 20 per cent in cash, bonds, and preferred shares - making it difficult to classify. While a dividend fund (particularly one that holds bonds) seems an odd choice for a "tax managed" fund, consider the following facts.

Kellett buys bonds mainly at a premium. In other words, he buys bonds that pay out higher than average interest payments but that sell at prices above the maturity value. The result is a higher interest yield and a capital loss at maturity. The higher level of interest is earmarked to pay the fund's fees and expenses, while the capital losses on the bonds are used to offset gains realized from selling stocks at a profit. It doesn't prevent distributions altogether, but it keeps them low. Dividend distributions totalled 1.9 per cent of assets in 2000, and 2.5 per cent in 1999. In 2000, capital gains equal to about 1.3 per cent were paid out to unitholders. Kellett's turnover rate on this fund has averaged 36 per cent over the past two years and fees are about 1.88 per cent per year. All things considered, this is a very good fund.

AIC ADVANTAGE

James Cole runs this "Warren-Buffett-like" fund, which makes it clear in their marketing material that they are long-term shareholders. In fact, it's an attitude that runs firm-wide at AIC. While I think they can get carried away at times, there is a sound investment philosophy underneath the tax-sensitive marketing. The style is based on three broad principles: buy good companies (in growth industries) at a reasonable price; keep a focused portfolio (20 to 25 stocks); and hold for a long period of time. James looks for companies with a long and profitable track record. When estimating a company's value, Cole zeroes in on a company's "free cash flow" (i.e. the cash flows that accrue to the benefit of common shareholders). Wealth management and financials remain the focus for half of the portfolio, with the remainder more broadly diversified.

When making investment decisions, do not compare this to the TSE 300 or other common benchmark. While the fund takes a sound approach to picking stocks, don't be wooed by its large outperformance of the TSE 300. A more appropriate benchmark would be something like 40 per cent TSE Financial Services and 60 per cent TSE 300. Hence, when comparing this fund's performance with more similar funds, it shows a string of underperformance for the past two years and so far this year. The four years ending December 31, 1998 saw a large margin of outperformance against other similar funds but the group was very small during that time totaling just a handful. Do not use this fund as a core holding. Rather, treat it as a good specialty fund by limiting exposure to no more than 10 to 15 per cent of your total portfolio.

UNIVERSAL FUTURE

Lead manager John Rohr initiated this uniquely Canadian technology mandate several years ago, when this fund was part of Mackenzie's Industrial family. It's is not a pure tech fund but that the emphasis. It holds about 50 to 60 percent in technology, about 20 percent in energy stocks, with the rest in cash and a diversified group of picks. The energy component nicely offsets the tech component to smooth out returns over time. Lead manager John Rohr also has a broad definition of technology, which gives him more flexibility to buy stocks that are leveraging technology to grow their business even if the technology itself isn't its core product. He generally limits any one stock to 6 percent of his total portfolio - though he makes the odd exception. Rohr is also more sensitive to high prices, as compared to other tech fund managers. Add in a low turnover rate of about 20% annually (i.e. average holding period of 5 years) and you've got a fund that is about as conservative as it gets when it comes to high tech holdings. As with AIC Advantage, don't treat this as a core holding. Rather, treat this as a specialty fund and limit your portfolio's exposure to this fund.

This article wouldn't be complete without mentioning two funds that actually use the term "tax-managed" in their names: MD Canadian Tax Managed Pool and MD US Tax Managed Pool. For those who don't know, MD Funds is a subsidiary of the Canadian Medical Association (CMA), and offers mutual funds and advisory services to its member physicians and their immediate families. These funds were excluded mainly due to the fact that the funds are relatively new and are run by MD Private Trust - the new money management arm of MD Funds. Turnover is expected to run in the 30 per cent range for both funds and each has a specific mandate of managing the tax implications of the investment process to minimize the impact on unitholders. Management fees are 1.25 per cent, so the final management expense ratio (MER) is expected to be in the 1.4 to 1.5 per cent range.

Generally speaking, index funds and exchange-traded-funds (ETFs) are also good choices for those looking to invest and minimize taxes. Broad-based index products generally have very low turnover (less than 10 per cent annually). However, it's important to look for index products that have low fees and a substantial amount of assets. Otherwise, you could end up with unplanned and unwanted tax consequences.

First and foremost, your choice of investments should be based on investment merit and suitability in the context of your objectives and constraints. Once attractive investments have been identified, then focus on those that will deliver the best after-tax rate of return. It's easy to get caught up in tax considerations but doing so may do you more harm than good.

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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