Tax Efficient Investment Products

Tax efficient investment products seek to minimize annual taxable distributions to the investor. This gives the investor the opportunity to keep more money that otherwise would have gone to Uncle Sam. But the portfolio management that leads to tax efficiency can sometimes hinder performance. The question becomes "Is it worth the compromise in performance for the gain in tax efficiency?"

Many factors can contribute to an investment product's tax efficiency. Some typical managerial methods include the following:

Maintaining low portfolio turnover -The more often a portfolio is turned over, the greater the likelihood of short-term capital gains. These gains are usually taxed as ordinary income, which is typically a higher rate that long-term capital gains. The difference between the two grows as the investor moves into higher tax brackets.

Favoring growth stocks, which do not typically pay a dividend -Another portfolio option is in the type of stocks held. Dividends are taxed as ordinary income and most value companies yield dividends. However, most "growth" companies are reinvesting their income at a rate that dwarfs or eliminates the dividend distributions.

Selecting companies that have share buy-back programs, instead of paying dividends-This is another dividend -related strategy, It accomplishes essentially the same goal as investing in growth stocks but it facilitates holding value stocks that gain value both from appreciation of stock and distribution of excess earnings.

Matching gains with losses when selling -This is primarily an accounting principle. The likelihood of it affecting a holding decision is less than one of the aforementioned strategies. Nonetheless, it is a strategy that lowers the tax exposure by buffering gains with losses.

Selling highest-cost stock lots first (HIFO) when possible -Highest In First Out (HIFO) is also an accounting principal. Like matching gains with losses, this is an attempt to take advantage of common accounting principles to lower the taxable gains on the portfolio.

All of these approaches and principles are beneficial in lowering the tax exposure, but should be secondary to the selection of stocks that are held in the portfolio. The portfolio manager can employ one or all of these strategies to "manage" the tax efficiency, but the benefit disappears if the pretax performance is not competitive. There a number of products that hold themselves out to be "tax-efficient" whose performance has been compromised and the benefit thus eliminated. However, some portfolio managers have done a very good job of balancing the two. A financial professional can help you discern between the ones that add value and the ones that compromise performance. And keep in mind, some funds naturally follow some of the tax efficient principles and have high levels of tax efficiency without holding themselves out as tax efficient. So if you are looking for products based solely on their tax-efficiency, be careful. You may be tripping over dollars looking for pennies.

Gadi Pollack

G. Pollack & Associates

The author is a registered representative of Jefferson Pilot Securities Corporation, member of NASD, SIPC. Branch office: Advisors Financial Group. He owns G. Pollack & associates located at 4400 Post Oak Parkway, Suite #1660, Houston, TX 77027. Phone Number (713) 659-1212.

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