Executive summary:
It’s important to understand the true meaning behind the names of investment funds, especially when it comes to those labeled “tax-managed”
Many mutual funds with “tax” in their names may consider investment taxes in their process
But only a “tax-managed” fund is obligated through prospectus to manage investments with a focus on reducing the tax burden
Many people believe that Chicago earned its nickname, “The Windy City,” due to its lakefront breezes and the winds that swoop through its skyscrapers. But in reality, Chicago isn’t even the windiest city in the U.S.; that title belongs to Boston, MA. Chicago actually ranks 12th in terms of windiness.1
So why is Chicago called the “Windy City”? The nickname originated during the World’s Fair of 1893 when a New York journalist claimed that Chicago was full of “hot air” politicians who boasted about their city in an attempt to secure the fair over New York City.2
This story highlights the importance of understanding the true meaning behind names—and this extends to your investments as well.
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.
