New Generation Of Tax Managed Funds By Frank Armstrong April 8, 2002

A third generation of tax managed index funds adds dividend management to capital gains management, enhancing the already formidable tax advantages that passive funds offer to investors. These new funds take tax efficiency to a new level.

Taxes - A dead drag on performance

Make no mistake about it, taxes are a dead drag on performance and the largest cost that investors bear. These cumulative costs greatly reduce nominal returns. Index funds are tax efficient by their very nature. Without a manager endlessly churning an account in the deluded pursuit of above market returns, turnover drops to much lower levels. And turnover is the chief culprit in creating taxable events. Capital gains are netted out and distributed to investors in the form of short-term capital gains or long-term gains dividends as appropriate. These dividends are then taxed at the investor's highest marginal rate ordinary or long term rate.

Early index investors were predominantly tax-exempt institutions and pensions that had little interest in tax efficiency. However, as individuals discovered the other benefits of index funds, they certainly appreciated the tax efficiency. As acceptance of passive investing spread to high net worth individuals, financial economists began to look for ways to further improve index fund tax efficiency.

First Generation - Total Market Funds

An early improvement in tax efficiency was realized by introducing total market funds. These avoided the turnover problems created when stocks grew into or fell out of an index like the S&P 500. Total market funds are more tax efficient than a market segment fund, but fail to capture diversification benefits or performance enhancements offered by tilting a portfolio to small or value. By their very nature total market funds do not allow for style management.

Second Generation - Capital Gains Management

Some funds were specifically designed to capture additional benefits associated with either the small or value premiums. While enhancing returns and reducing risk even after tax, these market segment funds were less efficient than a total market index. However, there are a number of well-known techniques to reduce the tax impact of these funds. These techniques are essentially capital gains management, and easily implemented.

• Hold stocks until they qualify for long-term gains treatment.
• Expand the hold range before a stock is eliminated from the portfolio.
• Utilize Highest In-First Out lot accounting.
• Harvest tax losses when available within the fund to reduce impact of realized gains.

Third Generation - Dividend management

Dividend management introduces very complex issues for the portfolio manager. However, dividends are taxed at the highest ordinary income rate of the owner, so controlling them introduces substantial benefits and important incremental gains in after tax return. Over time these incremental increases should significantly enhance total after tax returns.

Only about 20% of listed stocks actually pay a dividend. But, excluding them from a fund would fundamentally change the size and value weighting of the portfolio. This in turn will impact the expected return and risk of the fund.

Managing the tradeoffs between dividend reduction, transaction costs, style weighting, diversification, and capital gains requires a very powerful algorithm and some major computing time. Compared to capital gains management this really is rocket science! But, the incremental benefits in tax efficiency are quite satisfying. To date, only Dimensional Fund Advisors (DFA) has tackled the problem.