Managing 'Tax-Efficient' Funds Is a Tricky Business.

AMONG the strange self-contradictory expressions you hear in mutual-fund investing -- passive manager, for instance, or enhanced index fund -- the most incongruous of all may be "tax-efficient."

The idea sounds simple enough: Manage a fund with a constant eye on the tax consequences for investors. It has been adopted by Fidelity, Vanguard, T. Rowe Price, Eaton Vance and Lincoln National Corp.'s Delaware group, just to name a few that offer funds billed as tax-efficient or tax-managed.

But the execution is another thing. As any investor who has ever filed an Internal Revenue Service return knows, the tax rules covering mutual funds are so unwieldy they almost defy efficiency. It's no simple trick to be efficient when you try to manage a fund for maximum return while minimizing taxes at the same time.

"`Tax-efficient funds' often are not that tax efficient," said Mark Hurley, chief executive of the Dallas fund firm of Undiscovered Managers, who last year published a 30-page research study on the subject.

The tax issue arises because funds must pass along to their investors all profits they realize from any sales of investments each year. Any year the gain is large, the shareholders face a big tax bill, whether they themselves sell any of their fund shares or not -- and even if they reinvest the distributions. In the great bull market of the '90s, large gains have become almost routine.

"Tax-efficient" funds seek to avoid this unpleasantness by minimizing their realized gains. For instance, they try to take whatever losses they can to offset profits they cash in. They hang on to stocks that have been big winners, thus putting off the date of tax reckoning for those holdings.

That's good for current investors, since deferring taxes helps their money compound at the best possible rate. It may not be so good for investors who buy in the future.

"Often; tax-managed funds generate large unrealized gains," said Howard Present, director of product management and development at Putnam Investments, a Marsh & McLennan Cos. subsidiary that runs a $235 billion fund group in Boston. "When those gains are realized, they can penalize investors who had bought shares of the fund at a later date."

Last month, Present's company brought out the Putnam Tax Smart Equity Fund designed, Putnam said, "to give the fairest possible tax treatment to all investors in the fund."

The new fund will close an existing portfolio of securities to new investors whenever unrealized gains accumulate -- to, say, 15 percent to 25 percent of the portfolio's total value. Money that comes in after that will be invested in a new portfolio with the same managers, strategy and objectives as the first, Putnam said.

Before you invest in any tax-managed fund, there are two important points to ponder. First, if you pay too much attention to taxes, you can easily lose track of your primary mission, which is to make your money grow.

Secondly, all long-term tax planning is partly guesswork. When you defer taxes now, for example, you can't be sure what tax rate will apply, or what tax bracket you will be in, when you must settle up with Uncle Sam at some future date.

One of the simplest tax-planning strategies of all is to buy funds through a tax-deferred setup such as an individual retirement account, rendering the whole issue of distributions irrelevant. Since there are no current taxes to pay, tax-managed funds normally don't belong in IRAs, 401(k) plans and such.

Maybe it will be decades before you take any money out of an IRA or 401(k). When you do, though, you face taxes on every dollar withdrawn at ordinary income rates, which rise progressively to almost 40 percent for high-income taxpayers. Gains on shares held in a taxable account for more than a year are taxed at the maximum capital gains rate of 20 percent.

When you die, your heirs may be much happier to inherit fund shares you held in a taxable account than shares you owned through an IRA or 401(k). Death effectively clears the slate of capital gains that built up in your lifetime; there is no similar "step-up" for IRAs and 401(k)s.

Matter of time

Any time you ask a mutual fund manager how things are going, you really should specify what time period you have in mind.

Take the case of Charles Bath, manager of the $2.5 billion Nationwide Fund, who is simultaneously having a great week, a tough year and a pretty decent decade.

What made the week at Bath's Columbus, Ohio, fund was an outbreak of competing merger bids for the largest holding in its stock portfolio, Warner-Lambert Co.

The news helped propel Warner-Lambert shares to double-digit gains.

It will take more than that, though, to salvage 1999 for the fund, which has eked out a 3.7 percent gain year-to-date, trailing the benchmark Standard & Poor's 500 Index by 8.3 percentage points.

Bath has a simple explanation for the sluggish showing at his fund, which looks for stocks representing earnings growth and dividend income. He has a near-total aversion to Internet-related and other so-called technology stocks. This group is represented in his portfolio by a 2 percent position in IBM and nothing else.

"It's been a single-themed market in 1999 -- what's your technology weighting?" Bath said on a visit to New York.

He remains convinced that techs are riding for a fall like the "bloodbath" they experienced in the 1980s after an initial wave of enthusiasm among investors for personal--computer stocks. "It has all the symptoms of that period -- huge amounts of capital chasing a world-changing technology," he said.

Chet Currier is a columnist with Bloomberg News.