Tax Efficient Mutual Funds Gaining In Popularity In US

by Mike Godfrey, Tax-News.com, Washington

31 August 2001

According to recent reports, tax efficient mutual funds are gaining in popularity in the United States as a result of the increasingly vicious tax bite being taken from standard funds, and uncertain market conditions.

During the heady late 1990's, astronomical returns on many mutual funds meant that the tax burden related to capital gains on mutual funds was of little consequence. However, as the bubble burst for many US investors, tax efficiency became a matter of great importance. Estimates suggest that the average tax take from a standard mutual fund's total annual return is something like 2.5%, which makes a big difference if the returns are smaller to start with. 'The days of 100% gains are behind us,' explaine Morningstar analyst Bill Harding in an interview with BusinessWeek. 'We're in a time of more rational returns.'

Tax efficiency is set to emerge further into the spotlight with the forthcoming introduction of new SEC rules requiring mutual funds to be more transparent regarding their pre-tax and after-tax performance. By the end of this year, all US based mutual funds will be obliged to include standardised after-tax results in their prospectuses, a prospect which has sent industry groups into something of a frenzy.

Last year was a particularly bad year for mutual fund managers because of the fact that they were forced to sell still profitable stocks in order to meet redemption demands as the market crashed, thus locking in capital gains and increasing the tax burden for remaining investors. Tax efficient funds keep a rein on this by limiting the number of capital gains distributions, and holding shares for longer periods so that they will be taxed at lower capital gains rates than stocks held for a year or less.

However, experts are urging caution, even when looking at tax efficient mutual funds, as there can sometimes be hidden costs or traps such as minimum investment periods, early redemption penalties, and sizeable minimum investment levels.

Recommended