'Tax-efficient' funds may simply be closet indexers

Tax-managed mutual funds may simply be closet indexers, and expensive faux trackers at that.

That's according to a study of U.S. equity mutual funds classified as tax-managed, meaning they attempt to add value by both active management and keeping taxes at bay.

"They don't really do all that much better in terms of being tax efficient," said David Nanigian, of the American College and co-author of the study with Dale Domian of York University and Philip Gibson at Winthrop University.

"Even when the tax burden is lower, the incremental expenses charged by these funds above and beyond passive counterparts vastly exceed any incremental tax savings that they offered."

The arrival in early 2016 of tax forms will underscore once again the advantages of minimizing tax on investment. That's led to the advent of a $40 billion segment of U.S. equity mutual funds classified as tax-managed.

According to the study, published in the fall edition of the Journal of Wealth Management, the early results are not encouraging.

The study looked at performance among tax-managed funds from 2010 to 2014, comparing them with actively managed peers, passive mutual funds and passive exchange-traded funds.

That's another way of saying that these funds look suspiciously like closet indexers, mutual funds that hug the index, taking only relatively small bets on speculations they hope will generate outperformance.

Closet indexing may be a smart move for fund mangers, minimizing career risk, but investors end up paying quite a bit more for a product that may not be too different from a cheaply available index fund alternative.

"Tax-managed funds appear to follow the simple index-tracking strategies pursued by passively managed funds, yet they cost two to three times as much," the authors wrote in the study.

Expenses of tax-managed funds were statistically indistinguishable from those of their actively managed counterparts. Yet when you compare results, the tax-managed funds fail to save enough on taxes to outweigh their extra expenses when compared with passive funds.

There are primarily three ways in which you can manage a fund with taxes in mind. One is to minimize dividends, which pay tax at a higher rate than capital gains; second, by tax-loss harvesting, which means selling winners paired with losers where possible to offset taxes, and third, by avoiding short-term trading and the higher taxes charged on capital gains for assets held less than one year.

"It's possible but not likely," Nanigian said. "We don't notice a trend toward improvement over time."

That rather points to the alternative explanation: that calling oneself tax-managed is often essentially more marketing than reality, as funds seek to adopt protective coloring that will allow them to earn higher fees amid fierce competition.

Based on a reading of the study, investors wanting to minimize tax would do well to choose total market index funds — ones that track a very broad index of U.S. equities, such as the Wilshire 5000.

Index funds have a tax advantage as they don't buy or sell unless a share enters or leaves a given index, reducing the occasions that might generate a capital gain. The broader the index tracked, the less turnover you will get, something that keeps a lid not just on expenses but on tax. Over the study period, the mean tax burdens of total market index funds ranged from 0.407 to 0.521 percentage point, well below the 0.518 to 1.247 in mean tax borne by the broader group of index funds.

To be sure, the study covered only a few years — years with generally good stock market returns and low volatility. It may be that tax-managed funds do better in a choppier market, something we may well see as interest rates rise in the coming year.