I still have some money invested in mutual funds, holdovers from my pre-Fool days. In making my slow transition to Fooldom, I decided to just leave my existing investments in the mutual funds. This way, going forward  I could easily compare the performance of my new portfolio of lovingly handpicked companies with the performance of my mutual funds. After a couple of years of beating the pants off of my funds, I closed a couple and put the money into my online brokerage account.

I'm now down to having three mutual funds in my portfolio. One is an international growth fund. The second fund is for small and midcap growth companies in the U.S. The third is a blend of fixed-income investments and conservative stocks. This past week, I got a nasty little surprise from the small and midcap growth fund.

The letter from the fund was upbeat, of course. The performance of the fund for the first nine months of the year wasn't bad, considering the horrible year we've had. The nasty part was this: In a year in which the fund will probably emerge with a negative return, they managed to hit me with a taxable capital gain of almost 25% of the value of my investment! That's an amazing accomplishment when you think about it.

Let me put these percentages in context. Let's say you had $20,000 invested in this fund. If the fund ends up with a 0% return, hey, at least you still have your $20,000. You compare that to the S&P's 8% loss and the Nasdaq's 32% beating, and you're happy, all things considered. Hey, it could have been worse, you tell yourself. The fund did beat the S&P 500, after all. Then you realize that a capital gain of 25% of the value of your investment comes out to $5,000. If  you're lucky and all of those gains fall into the long-term category, you'll owe Uncle Sam $1,000 when you file your tax return next year. This in a year when you made no money. And you haven't beaten the S&P 500 after all.

By the way, our resident Fool on the Hill, Bill Mann, could have told me this was coming. (If you haven't read Bill's fabulous piece on the tax implications of actively managed mutual funds, you definitely should right now).  The bottom line is that there will be many, many investors this year who suffer the double-whammy of a nasty decline in investment value and a hefty capital gains tax.

Let's compare this with our Rule Maker portfolio. We had a great year in 1999, and paid a whopping $55.39 in taxes. This year has been horrible, and I don't expect we will see another one as bad as this one for many years. But we certainly aren't making it worse by paying any unnecessary taxes. We expect to have basically zero tax liability for the year 2000. And regardless of how good a year we have in 2001, I expect our tax liability to continue to be so small that it's immaterial to our performance. Keeping those dollars working for you instead of paying it out every year in the form of taxes makes a big difference in how much wealth an investor will accumulate over a lifetime of investing.

One of the advantages that a Rule Maker investing approach offers investors is the tremendous tax efficiencies that come with a low-turnover approach. The other advantage is that of control. In my own portfolio, I'm inclined to defer the payment of all those taxes and let that money compound in my account for another decade or two before making a check out to the IRS.

With actively managed funds, there will always be an element of surprise. I'm not able to manage my tax efficiency nearly as well, because I never know until the very end of the year what kind of tax liability I'm going to face. Here in the Rule Maker portfolio, we don't have to worry much about taxes. We sell our holdings very reluctantly, and when we do sell, we can immediately see what the tax implications would be and plan accordingly. Either way there won't be a big surprise at the end of the year. (By the way, if you do your own taxes, Matt Richey assures me that Quicken's TurboTax software is the best thing since sliced bread. Maybe that's why Matt is always doing something fun on the weekend before tax returns are due while the rest of us are looking bleary-eyed at our calculators!)

Now, I'm not against mutual funds, actively managed or otherwise. I believe there are some very good ones out there, and I encourage you to check out this great article by Matt Richey if you are interested in looking for Foolish mutual funds. As I mentioned, I have kept my money in a couple that have been good performers over the past five years. But I suspect the good ones try really hard not to hammer you with a big tax bill at the end of a money-losing year.

This is the second year out of three that this fund zapped me with a big tax bill after a year of poor performance. This tells me that they are more concerned with the pre-tax returns, which look good for their fund advertisements, than they are with the true after-tax returns to their fund investors. It's the after-tax returns that matter -- not those impressive numbers on the mutual fund advertisements in the glossy business magazines.

There is a proposal by the Securities & Exchange Commission (SEC) that would require companies to disclose the true returns, adjusted to reflect the taxes that would be paid by an investor in the fund in both the prospectus and in the annual reports describing the fund's performance. I believe that this would go quite a long way in helping investors choose mutual funds on the basis of true after-tax performance.

The advantages of low turnover, low stress, and low taxes make the Rule Maker strategy a very livable way to invest in the stock market. Speaking of which, it's time for us to make our $500 monthly investment. Phil and Matt voted for Yahoo! (Nasdaq: YHOO), and Rich voted for Intel (Nasdaq: INTC). When I look at the prices to which these two companies have fallen, I don't think we can go wrong either way. Nevertheless, my vote this month goes to Yahoo! due to the company's exceptional financial performance this year. 

That means the votes for December are in and we'll be purchasing additional shares of Yahoo! in the next five business days.

By the way, if you're not a registered Fool, I'd like to invite you to find out what you've been missing! Head over to our registration area to start yourself on a path to Foolish bliss. And have a great weekend!