You Don't Need This in Your Portfolio

If you hate paying taxes -- and most people do -- then you'll probably go well out of your way to avoid them. But one type of tax-sensitive investment has started to disappear, in the face of lack of interest from investors.

Mutual funds have long faced criticism about the taxes their investors have to pay. Even when fund shareholders reinvest distributions into more shares, they still have to pay taxes on them. To address this, fund companies created more tax-efficient mutual funds that would take steps to cut the tax burden that fund investors had to bear. But as interest in those funds has waned in light of lackluster performance, fund companies have begun closing such funds or merging them into other offerings.

How tax-managed funds work
The idea behind tax-managed funds is relatively simple. Typically, such funds use a variety of different strategies to try to minimize the amount of taxable capital gains they generate within their portfolios. That in turn cuts down on taxable distributions that the funds have to make to shareholders, which lowers your tax bill.

Tax-managed funds have a number of ways to accomplish their goal of keeping taxes low. By managing portfolio turnover, a fund can cut down on the number of trades it has to make, reducing the opportunities when it may have to realize capital gains. Alternatively, a fund can buy shares of stock at several different times, paying different prices each time. When it comes time to sell, the fund can choose the highest-cost shares, keeping any gain to a minimum.

These days, though, perhaps the easiest method for tax-managed funds to use to keep taxes down is to harvest enough tax losses to offset gains. For example, if a fund like Vanguard Tax-Managed Growth & Income (VTGIX) has a long-term gain on a stock like Apple (NASDAQ:AAPL) and needs to raise cash, it can sell shares of another stock that has had losses -- for this fund, a stock like General Electric (NYSE:GE), perhaps -- to offset those gains.

The cold shoulder
Reducing tax liability is a great thing for fund owners. But the problem that some tax-managed funds are facing is that the special steps they take to cut taxes aren't particularly necessary right now. Many traditional funds have accumulated significant losses that they can carry forward and claim against gains. Here are some examples from Vanguard, which publishes such figures on a daily basis:

Source: Vanguard, Morningstar.

These funds don't have much to worry about right now from a tax perspective, because even if they rise significantly from today's depressed levels, they have lots of loss carryforwards to use up before they have to pass through any taxable gain to fund shareholders.

Because regular funds already have some protection from taxes, there's less demand for tax-efficient products right now. That's why many fund shops are closing down or merging out their tax-managed funds. PIMCO, for instance, is liquidating one of its tax-efficient funds, while T. Rowe Price will merge two of its weaker-performing tax-efficient funds into other funds.

What to do
If you're concerned about having to pay taxes on your mutual funds, finding out whether or not your fund has loss carryforwards that will help prevent you from getting any taxable distributions in the future is as simple as contacting your fund company or finding the information on its website.

But with so many funds having seen such severe losses over the past couple of years, odds are good that you won't have to worry about taxable gains for quite a while. And with things the way they are, tax-managed mutual funds aren't nearly as valuable to have in your portfolio as they once appeared to be.

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