How to Screen Mutual Funds For Tax Efficiency

Reuters

Lipper’s Fund & ETF Screener, which enables you to learn much of what you may want to know about any of over 22,000 mutual funds and fund share classes, can be especially helpful in screening both the tax efficiency and the pre-tax performance of the current 55 tax-managed equity and mixed asset funds tracked by this major fund data and research firm.

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Starting with the hypothetical, standardized after-federal-tax returns which a 2001 Securities and Exchange Commission rule requires mutual funds to calculate and disclose, the Screener enables you to compare the tax efficiency of competing funds.

To comply with the rule, funds must expand on the SEC’s formula for calculating pre-tax annual total returns for one-, five-, and 10- year periods by estimating hypothetical after-tax returns in two ways: (1) after taxes on actual fund distributions and (2) after taxes on actual fund distributions and on the assumption that an investor has sold all of his/her fund shares.Let’s just focus on the distributions-only data.

For purposes of the calculation, the SEC asks funds to use the maximum marginal income tax rates that had prevailed in the one-, five-, and 10-year periods. (If you were not in the top bracket, you need to figure out your own personal after-tax returns, using your federal tax rates — and, of course, your state income tax rate, if any.)

To determine a fund’s relative tax efficiency for a five-year period — a more meaningful period for analysis than one year — the Screener divides the after-tax return by the pre-tax return, makes some adjustments, and comes up with a figure.

It then ranks these results for all the funds in an investment objective category and divides them into quintiles. The top 20% get a grade of five; the bottom 20%, a one.

To illustrate how the Screener works, let’s find a highly tax-efficient, tax-managed fund in the popular large-cap core category, whose annual average pre-tax return for the last five years was a tiny 1.9%, even lower than the Standard & Poor’s 500’s 2.3%.

Go to www.reuters.com/funds, and under the headline Fund & ETF Center, please find and click Fund & ETF Screener.

1. Click Mutual Funds.

2. Click Equity Funds.

3. Under Additional Fund Attributes, arranged alphabetically in batches, click K-O. When you see Large Cap Core in the right column, check and click it. You’ll find there are 1,052 matches.

4. Drop down to 5-year pre-tax total returns in the left column and go to the right to click the 5-10% range. The number of matches is now 31.

5. Drop down to tax efficiency in the left column and go to the right to click 5, the highest rating. The number of large cap core funds rated high is, coincidentally, also five.

6. Click to view the five funds or fund share classes that were rated five.

7. You’ll find Brown Brothers Harriman’s Core Select Class N shares top the list with an average annual total return of 6.74% for the last five years.

Fortunately for this test of the Lipper Screener, the fund’s investment objective — “to provide investors with long-term growth of capital on an after-tax basis” — says unambiguously that it is a tax-managed fund. Clicks of other attributes might have had a different result.

Started in 1998, the fund was once named the BBH Tax Efficient Equity Fund. After BBH brought in new management in 2005, it changed the fund’s investment criteria and, ironically, its name — but not its emphasis on after-tax returns, as co-portfolio manager Timothy E. Hartch points out and as the five-year tax efficiency ranking indicates.

(The shares are available without a sales load directly from BBH, which requires a minimum initial investment of $10,000, and certain brokers, which have $5,000 minimums.)

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