Investing in tax-managed funds

Investing in mutual funds that strive to keep their tax bite to a minimum

can put extra money in your pocket. Why? Because it's not what your fund

earns but what you keep that counts.

By law, mutual funds must distribute 95 percent of their realized gains,

and the tax bite from those distributions reduces the average fund's return

by 2.6 percent. That is a significant sum when you consider that the average

annual return for U.S. diversified mutual funds during the past 10 years

is 13.8 percent.

One solution is to invest in "tax-managed funds." Among this group, the

Schwab 1000 fund (SNXFX) is one of the most highly regarded. Another successful

tax-managed fund is the Vanguard Tax-Managed Growth and Income fund (VTGIX).

Both funds are tax-efficient and have outperformed the S&P 500 for the

past three years.

There are about two dozen funds that actively seek to minimize investors'

taxes. Portfolio managers employ several techniques to achieve this objective:

* They keep portfolio turnover low because selling shares that have appreciated

will generate taxable gains.

* They buy growth stocks that pay little or no dividends because dividends

are taxed as regular income.

* They practice "tax loss selling," which entails selling a stock that's

declined in value to offset realized gains from stocks already sold for

a profit.

Advocates of tax-managed funds contend that managing tax liability is one

of the few variables investors can control. Most funds don't announce their

after-tax returns, only their pre-tax performance.

At times, the disparity between pre-tax returns and after tax returns can

be quite large. Of course, not all tax-managed funds are stellar performers,

so investing in them requires careful selection. You don't want to invest

in a tax-managed fund if it's after-tax returns lag its non-tax-managed

peers. For example, the Eaton Vance Tax-Managed Growth Gund (ETTGX), lagged

the S&P 500 by 5.58 percent in 1999.

Zall is a freelance writer based in Silver Spring, Md., who specializes

in taxes, investing and business issues. He is a certified internal auditor

and a registered investment adviser. He can be reached via e-mail at miltzall@starpower.net.

To read more from Milt Zall (Bureaucratus), type "Zall" in the search box

at www.fcw.com.