Tax Savings on Mutual Funds

A new manager at your mutual fund can provide constructive adjustments - and also a bigger tax bill - eradicating any hope of tax savings.

Mutual fund manager tenure is shrinking, perhaps due to tighter industry competition: A recent study showed that the average mutual fund manager had been on the job for 4.44 years, down from 5.26 years when measured two years earlier.

For mutual fund investors, changes can potentially be good: New managers can deliver new suggestions to the fund and potentially increase profit. But these brand new ideas are a double-edged sword: If the new manager sells unwanted holdings inherited from a predecessor, she or he can generate capital gains, which will create for you just the complete opposite of tax savings. Even though you may reinvest those gains, you still pay tax on them.

As an example, think about the typical yearly portfolio turnover for brand new managers. Portfolio turnover measures the value of investments bought and sold yearly compared to the fund's total fund assets. For example, a portfolio turnover of 100% indicates the fund holds shares, on average, for one year. A portfolio turnover of 200% indicates the fund maintains stocks for 6 months.

According to Morningstar, the average annual portfolio turn over for a manager who has been on the job 2 yrs or less is 98.65%, compared to 87.67% for a fund manager who has been on the job longer than two years. The lower the turnover, the greater the potential tax savings from holding such fund shares (low turnover funds generate the least taxes).

Just how much can portfolio turnover affect you? For example, in the spring of 2006, one Fidelity fund realized $9.7 billion, nearly one-fifth of the fund's net asset value in capital gains and returns after new management reshuffled the huge fund's portfolio. Investors would've needed to look for tax offsets with other investment strategies in order to experience any tax savings that year.

Does that imply you should leave a fund which has a portfolio manager change? Not really. Doing so may aggravate your tax hit, because in addition to owing capital gains taxes on the fund's distributions, you'll own capital gains taxes on your sale.

Instead, you might want to gain a sense of how much a new manager is changing the fund by looking at the fund's portfolio turnover. Many funds also publish changes on the fund's website. You may also want to evaluate a tax hit in light of a fund's past performance. You can also look at the previous money that the new fund manager has directed. He might be an advocate of a reduced turnover strategy that brings you tax savings. If your fund has had a great average yearly return over the past 5 years, it may be easier to tolerate the capital gains taxes which will be a one-time event as the new manager realigns the portfolio to his liking. But when your fund performed badly, capital gains taxes may be the addition of insult to injury.