What’s in a Name? Understanding Tax-Managed Funds and Strategies

Understanding investment terms: Tax-aware, tax‑efficient, tax-advantaged, tax-managed

The investment world is filled with terms like tax-aware, tax-efficient, tax-advantaged, and tax-managed. But what do these terms actually mean, and why should you care?

There are more than 600 mutual funds in the U.S. with the word "tax" in their title.³ Some are tax‑exempt or tax-free, such as municipal bond funds, and typically fixed income bond funds. What about the rest though? The ones that use tax-aware, tax-sensitive, tax‑advantaged, and tax-managed in their names. Are they all the same?

No, there are significant differences.

• Tax-aware, tax-sensitive, and tax-advantaged describe aspects of the overall process but don't imply action.
• Tax-managed implies active management with a focus on taxes.

Breaking down the lingo:

• Tax-aware: Simply being aware of a tax situation doesn't mean you're addressing it. It implies acknowledgment but not necessarily action.
• Tax-advantaged: This term suggests a benefit over peers or other similar investment products, but it doesn't mean the issue is fully addressed or even addressed meaningfully.
• Tax-efficient: Commonly used with Exchange-Traded Funds (ETFs), this term means there are fewer and therefore typically lower capital gains distributions compared to mutual funds.

The issue with these terms is that they don't explicitly tackle investment taxes head-on. Often, funds described in these terms swap out fixed income for municipal bonds, which is a limited approach. Unless a fund is explicitly "tax-managed," it must, by prospectus, manage the portfolio for both qualified and non-qualified investors, diluting its tax efficiency.

The importance of the term "tax-managed"

A fund or model with "Tax-managed" in its title is obligated by its prospectus to manage the portfolio as if it were 100% non-qualified and exposed to taxes. Just as a country‑specific fund must invest at least 80% of its assets in that country, a tax‑managed fund is focused on maximizing after-tax returns.

By including "tax-managed" in its title, a fund manager can employ various strategies to minimize capital gains. These strategies include:

• Tax Loss Harvesting: Systematically realizing losses to offset gains, reducing overall tax liability.
• Wash Sale Minimization: Carefully timing re-entry into positions to avoid wash sale rules, which consider the implications of holding a position for 30 days versus 31 days.
• Holding Period Management: Strategically holding positions to benefit from the tax rate difference between short-term (less than 365 days) and long-term (more than a year capital gains.
• Optimal Tax Lot Selection: Using specific tax lots to offset gains from other lots, thus reducing embedded capital gains.
• Fund Yield Management: Implementing yield through tax-efficient sources of income.

Funds with "tax-aware," "tax-efficient," or "tax-advantaged" in their titles are not necessarily deploying the same tools as a tax-managed fund since these descriptors don't imply a required action. As a result, they may not be optimizing after-tax wealth to the extent that a tax-managed fund is able to.

What about ETFs?

A common response we often hear is, "I'll just invest in ETFs since they're inherently more tax-efficient than typical mutual funds." And you're right! As the table below shows, ETFs (light blue) are naturally more tax-efficient than traditional mutual funds (dark blue). However, they don't match the level of tax efficiency achieved by tax‑managed funds (medium blue).

Tax-managed: funds identified by Morningstar to be tax-managed.

Universe averages*: Created table of all U.S. equity mutual funds and ETFs as reported by Morningstar. Calculated arithmetic average for pre-tax, post-tax return for all shares classes as listed by Morningstar.

Morningstar Categories included: U.S. ETF Large Blend, U.S. ETF Large Growth, U.S. ETF Large Value, U.S. ETF Mid-Cap Blend, U.S. ETF Mid-Cap Growth, U.S. ETF Mid-Cap Value, U.S. ETF Small Blend, U.S. ETF Small Growth, U.S. ETF Small Value, U.S. OE Large Blend, U.S. OE Large Growth, U.S. OE Large Value, U.S. OE Mid-Cap Blend, U.S. OE Mid-Cap Growth, U.S. OE Mid-Cap Value, U.S. OE Small Blend, U.S. OE Small Growth, U.S. OE Small Value.

*Methodology for Universe Construction on Tax Drag chart: From Morningstar, extract U.S. equity and fixed income mutual fund and ETF's for reported period. Averages calculated on a given category. For example, average after-tax return for the large cap category reflects a simple arithmetic average of the returns for all funds that were assigned to the large cap category as of the end date run. For funds with multiple share classes, each share class is counted as a separate "fund" for the purpose of creating category averages. Morningstar category averages include every type of share class available in Morningstar's database. Large Cap/Small Cap/Municipal Bond determines based upon Morningstar Category. If fund is indicated by Morningstar as passive or an ETF, the fund is considered to be passively managed. Otherwise, the fund is considered to be actively managed. Tax Drag: Pre-tax return Less After-Tax Return (pre-liquidation).

While it is true that index mutual funds (passively managed) and Exchange-Traded Funds (ETFs) are more tax efficient than traditional mutual funds (actively managed), that is simply a byproduct of their construction and function. Index funds generally have fairly low turnover and tend not to pay out distributions. They also benefit from a mechanism that allows them to 'sweep away' some tax impacts through the in-kind share creation-redemption process (a topic for another day). However, sometimes stocks are removed from indexes with market-cap constraints or factor tilts when they no longer meet the indexes' criteria for inclusion. These events can and do generate realized capital gains. In addition, since most ETFs replicate passive indexes, they receive dividends from their underlying holdings. This includes both qualified and non‑qualified dividends, which come with sometimes sizable tax implications. In addition, ETFs that use derivative contracts for activities such as currency-hedging have additional tax impacts and taxable distributions. While ETFs are relatively tax-efficient because of their in-kind security exchange ability, they are limited in their ability to manage the myriad of other items that generate tax cost.

More importantly, these types of investment vehicles do not have an explicit obligation to minimize their investors' tax burden and generally do not carry the label of "tax‑managed" in their names. Instead, they are just referred to as "tax efficient".

Tax-managed mutual funds may have the same general objective to outperform the S&P 500 Index as a traditional mutual fund and may also own a similar combination of stocks to achieve that goal. The key difference is that a tax-managed mutual fund takes proactive measures to minimize taxable transactions within the fund (i.e., buying and selling of securities).

This often starts with a long-term focused investment process, which naturally reduces trading activity and the more tax-costly short term capital gains trades. The investment team can also select specific tax lots to trade rather than using more tax-naïve methodologies; this can result in a lower or no realized capital gain when the trade is effected. Additionally, the investment team can actively harvest taxable losses throughout the year to offset current and future gains. There are many techniques and strategies an investment team can use within a Tax-Managed Fund to minimize tax impact and maximize after-tax returns.

Traditional mutual funds are very limited by the fact that they need to prioritize qualified accounts first and cannot use such tax-loss harvesting strategies or tax management techniques on the investments they own.

These activities are the key distinction in how tax-managed mutual funds work differently than their traditional counterparts, even those funds with "tax aware" or "tax advantaged" in their names.

The bottom line

Next time you review your portfolio and see the word "tax" in a fund's title, take a closer look. If it's not tax-managed, it might not be addressing your tax concerns as effectively as it could.

¹ Source: https://www.currentresults.com/Weather-Extremes/US/windiest-cities.php

² Source: https://www.history.com/news/why-is-chicago-called-the-windy-city

³ Source: Morningstar Direct

Disclosures

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.

This material is not an offer, solicitation or recommendation to purchase any security. Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment. The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual entity.

MORNINGSTAR CATEGORY DEFINITIONS:

U.S. Fund - Large Value: Large-value portfolios invest primarily in big U.S. companies that are less expensive or growing more slowly than other large-cap stocks. Stocks in the top 70% of the capitalization of the U.S. equity market are defined as large cap. Value is defined based on low valuations (low price ratios and high dividend yields) and slow growth (low growth rates for earnings, sales, book value, and cash flow).

U.S. Fund - Large Blend: Large-blend portfolios are fairly representative of the overall U.S. stock market in size, growth rates, and price. Stocks in the top 70% of the capitalization of the U.S. equity market are defined as large cap. The blend style is assigned to portfolios where neither growth nor value characteristics predominate. These portfolios tend to invest across the spectrum of U.S. industries, and owing to their broad exposure, the portfolios' returns are often similar to those of the S&P 500 Index.

U.S. Fund - Large Growth: Large-growth portfolios invest primarily in big U.S. companies that are projected to grow faster than other large-cap stocks. Stocks in the top 70% of the capitalization of the U.S. equity market are defined as large cap. Growth is defined based on fast growth (high growth rates for earnings, sales, book value, and cash flow) and high valuations (high price ratios and low dividend yields). Most of these portfolios focus on companies in rapidly expanding industries.

U.S. Fund - Mid-Cap Value: Some mid-cap value portfolios focus on medium-size companies while others land here because they own a mix of small-, mid-, and large-cap stocks. All look for U.S. stocks that are less expensive or growing more slowly than the market. Stocks in the middle 20% of the capitalization of the U.S. equity market are defined as mid-cap. Value is defined based on low valuations (low price ratios and high dividend yields) and slow growth (low growth rates for earnings, sales, book value, and cash flow).

U.S. Fund - Mid-Cap Blend: The typical mid-cap blend portfolio invests in U.S. stocks of various sizes and styles, giving it a middle-of the-road profile. Most shy away from high-priced growth stocks but aren't so price-conscious that they land in value territory. Stocks in the middle 20% of the capitalization of the U.S. equity market are defined as mid-cap. The blend style is assigned to portfolios where neither growth nor value characteristics predominate.

U.S. Fund - Mid-Cap Growth: Some mid‑cap growth portfolios invest in stocks of all sizes, thus leading to a mid-cap profile, but others focus on midsize companies. Mid-cap growth portfolios target U.S. firms that are projected to grow faster than other mid-cap stocks, therefore commanding relatively higher prices. Stocks in the middle 20% of the capitalization of the U.S. equity market are defined as mid-cap. Growth is defined based on fast growth (high growth rates for earnings, sales, book value, and cash flow) and high valuations (high price ratios and low dividend yields).

U.S. Fund - Small Value: Small-value portfolios invest in small U.S. companies with valuations and growth rates below other small-cap peers. Stocks in the bottom 10% of the capitalization of the U.S. equity market are defined as small cap. Value is defined based on low valuations (low price ratios and high dividend yields) and slow growth (low growth rates for earnings, sales, book value, and cash flow).

U.S. Fund - Small Blend: Small-blend portfolios favor U.S. firms at the smaller end of the market-capitalization range. Some aim to own an array of value and growth stocks while others employ a discipline that leads to holdings with valuations and growth rates close to the small-cap averages. Stocks in the bottom 10% of the capitalization of the U.S. equity market are defined as small cap. The blend style is assigned to portfolios where neither growth nor value characteristics predominate.

U.S. Fund - Small Growth: Small-growth portfolios focus on faster-growing companies whose shares are at the lower end of the market-capitalization range. These portfolios tend to favor companies in up-and-coming industries or young firms in their early growth stages. Because these businesses are fast-growing and often richly valued, their stocks tend to be volatile. Stocks in the bottom 10% of the capitalization of the U.S. equity market are defined as small cap. Growth is defined based on fast growth (high growth rates for earnings, sales, book value, and cash flow) and high valuations (high price ratios and low dividend yields).

U.S. Fund - Foreign Large-Blend: Foreign large-blend portfolios invest in a variety of big international stocks. Most of these portfolios divide their assets among a dozen or more developed markets, including Japan, Britain, France, and Germany. These portfolios primarily invest in stocks that have market caps in the top 70% of each economically integrated market (such as Europe or Asia ex-Japan). The blend style is assigned to portfolios where neither growth nor value characteristics predominate. These portfolios typically will have less than 20% of assets invested in U.S. stocks.

U.S. Fund - Diversified Emerging Markets: Diversified emerging-markets portfolios tend to divide their assets among 20 or more nations, although they tend to focus on the emerging markets of Asia and Latin America rather than on those of the Middle East, Africa, or Europe. These portfolios invest predominantly in emerging market equities, but some funds also invest in both equities and fixed income investments from emerging markets.

U.S. Fund - World Large-Stock Blend: World large-stock blend portfolios invest in a variety of international stocks and typically skew towards large caps that are fairly representative of the global stock market in size, growth rates, and price. World large stock blend portfolios have few geographical limitations. It is common for these portfolios to invest the majority of their assets in developed markets, with the remainder divided among the globe’s emerging markets. These portfolios are not significantly overweight U.S. equity exposure relative to the Morningstar Global Market Index and maintain at least a 20% absolute U.S. exposure.

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