(By Adam Zoll) Investors are keeping a watchful eye on fiscal cliff negotiations in Washington, and with good reason. After all, the Congressional Budget Office projects that if tax rates do rise and federal spending is cut, as is scheduled to happen Jan. 1, it would plunge the economy back into recession in 2013.
There's no way to know what's going to happen, of course, but changes scheduled to go into effect include an increase in long-term capital gains rates, from the current 15% top rate to 20%, while dividends would go from the current 15% rate to being taxed at ordinary income rates.
For investors holding mutual funds in taxable accounts, such increases likely will mean reductions in aftertax returns, especially for those owning funds with heavy distributions, such as capital gains from the fund selling stocks at a profit and from dividends paid out to shareholders. (For more on the fiscal cliff and its impact on investors, visit Morningstar's Navigating the Fiscal Cliff Special Report.)
One way to assess the tax efficiency of a mutual fund is by checking its tax-cost ratio, which measures the degree to which a fund's annualized returns are reduced by taxes investors pay on distributions. A 1% tax-cost ratio, for example, means investors lost an average of 1% of returns to taxes. To find this metric for any fund on Morningstar.com, go to the fund's Quote page and click on the Tax tab. There you'll find tax-cost ratio data for a variety of time periods and can compare the fund's tax-cost ratio with that of other funds.
Along with having tax concerns, some investors expect ongoing uncertainty regarding the fiscal cliff and the economy in general to add volatility to the stock market. The Morningstar Risk metric, found under the Ratings & Risk tab on a fund's Quote page, reflects the variations in a fund's returns relative to its peers' during various time periods, with an emphasis on downside variations because those are the ones that concern investors the most. The lower the risk rating, the less volatility the fund has shown relative to its peer group.
Of course, a low Morningstar risk rating and low tax-cost ratio alone do not mean a fund is worthy of your investment. Some very good funds may have high tax-cost ratios (making them better candidates for tax-advantaged accounts such as an IRA) or risk ratings. But with the fiscal cliff very much in the news and on our minds lately, we decided to use Morningstar's Premium Fund Screener tool to find quality funds that might appeal to investors fearful that high volatility and higher taxes lie ahead.
We limited our search to domestic-stock funds and screened on those with below-category-average five-year tax-cost ratios and Morningstar Risk ratings of below average. To weed out funds that may have these characteristics but shortcomings elsewhere, we limited our search to those rated Bronze or better by Morningstar's fund analyst team. We further narrowed our search by screening only on no-load funds and noninstitutional share classes that are currently open to new investors and with minimum initial purchase limits of $10,000 or less. Premium members can see the full screen . Below are two of the names on it.
Amana Trust Growth (AMAGX)
5-Year Tax-Cost Ratio: 0.04% | Morningstar Risk Rating: Low | Designed for Muslim investors but open to anyone, this large-growth fund, which screens out stocks that get significant revenues from alcohol, tobacco, and other areas prohibited under Islamic law, has been a strong long-term performer. The fund also is not allowed to engage in excessive trading, and its low 12% turnover rate aids in tax efficiency. Its ban on investing in companies that receive interest keeps it out of financials, which helped it beat the S&P 500 by more than 7 points in 2008, but this also means the fund hasn't participated in the sector's rebound. The fund's one- and three-year annualized returns land it in or near the bottom quartile of its category while its five- and 10-year returns are both in the top 20th percentile. Expenses are 1.13%, above average for a large-cap, no-load fund.
Baron Small Cap (BSCFX)
5-Year Tax-Cost Ratio: 0.28% | Morningstar Risk Rating: Below Average | Analyst Rating: Bronze
At 1.31%, this fund's expense ratio isn't egregious for the small-cap no-load group. But it's no bargain either, and its asset base of $4 billion also is rather large and potentially problematic for a small-cap fund. However, Morningstar fund analyst Christopher Davis says the fund's veteran management makes it an attractive option. Manager Cliff Greenberg looks for stocks that can double in size during the coming four to five years, an approach that keeps turnover (33% during the past year) in check. Steady growers with strong competitive advantages are favored. Although categorized as a small-growth fund, about half the portfolio is in mid-caps. The fund's five-year annualized returns are roughly on par with the category average, but its 10-year annualized returns beat the category by 1.4 percentage points.
Tax-cost ratio and Morningstar Risk ratings as of Oct. 31; fund performance data as of Nov. 26.