A Tax-Efficient Mutual Fund

Given the new investor interest in the tax implications of mutual fund holdings, it is worth examining exactly what it means for a mutual fund to be tax efficient. As an example, we consider an actively managed tax-efficient fund, Eaton Vance Tax-Managed Growth 1.1 A shares. Note that, in terms of our discussion in earlier chapters, we are considering here the class A shares, which carry a 5.75 percent initial sales charge. The expense ratio is 0.77 percent.

The Eaton Vance Tax-Managed Fund showed the performance given in Table 19-1 through the end of 2001, using average annual returns (all figures are from Morningstar 's Web site).

Table 19-1. Eaton Vance Tax-Managed Fund Performance Through 2001

	3-Year Average	5-Year Average
	%	%
Pretax return	2.77	12.47
Tax-adjusted return	2.77	12.45
Tax-efficiency ratio	100	99.77

As you can see, this return has an after-tax return that is virtually identical in both periods to the pretax return, hence the 100 percent tax-efficiency ratio, or very close to it. Investors get to keep what they make, which is certainly not the case for some other funds.

The trend now is to rate funds on their tax efficiency. Go to the Morningstar Web site at www.morningstar.com and look at the page for a fund and you can find its tax-efficiency ratio. The SEC now requires mutual funds to report both pretax and after-tax returns. The rationale is that investors will be able to compare funds more effectively by seeing both sets of return numbers .

Some observers believe that for most mutual funds (those not specifically being tax-managed) tax efficiency tends to be unpredictable. In other words, funds can be tax efficient in some years , and then this efficiency can disappear very quickly. For example, when a fund is forced to sell securities to pay for shareholder redemptions, the tax efficiency can disappear.

As additional evidence for the randomness of tax efficiency for many funds, Morningstar produced a list of the 10 most tax-efficient funds over the preceding 10 years (excluding mutual funds specifically designated as being managed for tax efficiency). Only one of these funds was also on the list for the past five years and the past three years. Thus, according to some, a high degree of randomness is indicated. Finally, the fund that did make all three lists was in the bottom 20 percent of performance among its peer group for the 10-year period. ^[6]

^[6] See Anne Kates Smith, "Penny Wise," Kiplinger's Personal Finance , December 2001, available on the Kiplinger Web site.