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`Tax efficient’ mutuals don’t always deliver

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Mutual-fund ratings often include rankings of how "tax efficient" each fund is. These ratings compare funds' annual returns after accounting for taxes paid by shareholders on annual fund distributions.

Unfortunately, it's of little value to make such comparisons, because they are highly unlikely to make any measurable difference in your after-tax returns.While some financial advisers consider tax efficiency to be a key element in selecting a fund, most investors should ignore such advice.

Here's why:

- Investing in tax-efficient funds makes only an infinitesimal difference unless a fund is extremely tax-efficient. Take two funds: One is extremely inefficient and pays out all its taxable gains every year; the second is quite efficient and pays out capital gains only every three years. At the end of three years, the tax-efficient fund has produced a meager 0.2 percentage point more each year for shareholders in the 28 percent income-tax bracket.

To gain any significant benefit, a tax-efficient fund must delay realization of capital gains for at least a decade, preferably longer. But the average fund realizes half its capital gains each year, and virtually no funds delay capital gains for 10 years.

- On average, investors hold funds for five years or less, and selling a fund completely wipes out its tax efficiency.

"Every time you sell a fund, you make it completely tax-inefficient," notes Susan Belden, editor of No-Load Fund Analyst.

- It's tough to predict which actively managed funds will be tax-efficient in the future. For instance, a fund may have a history of not realizing many taxable gains, but a new manager may sell a chunk of the portfolio, handing investors a huge taxable distribution.

A study by Morningstar, the mutual-fund research firm, found that funds ranked in the top third for tax efficiency between 1991 and 1993 had little better than a 40 percent chance of remaining in the top third in the subsequent three years.

- Low turnover does not equal tax efficiency. Royce Pennsylvania Mutual, for instance, which turns over only about 10 percent to 20 percent of its portfolio annually, hasn't been tax-efficient, while American Century's Twentieth Century Vista (which has roughly a 100 percent turnover ratio every year) has been very tax-efficient.

The reason is simple: "We're not selling our winners; we're selling our losers," says Vista co-manager Glenn Fogle.

Value-oriented Pennsylvania Mutual follows the opposite strategy.