Understanding Tax-Managed Funds

Tax-managed funds are those in which tax effects are incorporated in the fund manager’s decision-making process. The manager of such a fund is guided in her buying and selling decisions, in part, by considerations of how to avoid incurring excessive capital gains taxes in any given year. For example, suppose that Jane Goodbucks is the manager of Fund T, a tax-managed fund. Jane may be contemplating selling the fund’s shares of Microsoft, the giant software company, because she and her research staff expect the value of Microsoft stock to increase at a rate of just 10% a year during the next several years — a little lower than Jane would like. Jane is considering replacing her Microsoft stock with shares of Amazon.com, the online retailer, which she expects to grow at 11% a year.
If Jane ignores tax effects, she is likely to sell the Microsoft stock and buy Amazon.com. But because Fund T is a tax managed fund, Jane first considers the cost her shareholders can expect to incur for capital gains. The taxes due will depend on the amount of the gains realized, which will depend, in turn, on how long Fund T held Microsoft and how far the stock increased during that time. Based on these considerations, Jane may or may not decide to sell Microsoft. Due to the effect of taxes, trading Microsoft for Amazon.com may result in lower returns for investors, so holding the Microsoft shares may be the better choice. You can find out whether a fund is tax-managed by reading the fund prospectus. Unless the prospectus states otherwise, assume the fund is not tax-managed. If tax considerations are important to you, consider focusing your fund choices specifically on those that are managed with tax effects in mind.