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Can Active Strategies Be Tax Efficient

Mutual fund investors with taxable accounts are often advised to look for low turnover funds and passively-managed strategies because it’s assumed that funds that don’t trade very much will realize fewer capital gains, leading to lower taxes and hence a potentially higher return.  This is sometimes true.  But that approach puts the tax cart in front of the investment horse.  We believe that the best predictor of after-tax return is pre-tax return.  We believe managing a portfolio to achieve strong long-term returns makes more sense than making taxes your chief priority.

Turnover and Taxes

Keep in mind that low turnover doesn’t always result in low taxes.  For one example, in 2008 many shareholders redeemed their mutual fund shares in the face of a fast-declining market.  Many low turnover funds were forced to sell shares of their long term holdings in order to accommodate liquidations, thus realizing larger taxable gains.  Actively managed funds may have higher portfolio turnover but these funds can often meet shareholder redemptions by realizing smaller gains or even losses (which can then be used to offset future gains).

Actively Managed Funds Can be Tax Efficient

Moreover, an active investment approach does not necessarily lead to an excessive tax burden.  The FundX Upgrader Funds are actively managed funds that attempt to take advantage of changing market leadership. Nevertheless, FUNDX has historically been quite tax efficient, distributing primarily long term capital gains (which are taxed at a lower rate than short term capital gains).  This is because we commonly hold high-ranking funds and ETFs longer than 12 months, whereas the funds we sell in less than that time tend to have had lower returns or even losses.

Before and After Tax Returns

In the table, below, we show the pre-tax and post-tax returns of the FundX Upgrader Fund (FUNDX) for the one and five year periods and since inception November 1, 2001 through June 30, 2011.  For one year, the difference between pre-and after-tax returns is only slight when we assume the shares aren’t sold (taxes on distributions only). When the shares are sold within one year, the gains are treated as short term and are taxed at a higher rate.  When we look back at five years and since inception, the difference is less than one percentage point.

An important factor to keep in mind is the tax-loss carry-forward that is built into the current FUNDX share price.  Because our active strategy prompted us to sell funds as they fell in our ranking system, we realized capital losses.  Some of those realized losses have yet to be used to offset capital gains.  As a result, Morningstar.com notes that “potential capital gains exposure” for the fund is a negative 25.82%. In other words, we can realize gains totaling over 25% of the current value of the portfolio (as of June 30) before we will have the need to distribute capital gains from our own trading activity.

Now, that’s tax efficiency.

Remember, you can turn to the prospectus to find the before and after tax returns for all of the FundX Upgrader Funds.

FundX Upgrader Fund ( FUNDX ) Average Annual Total Returns Periods ending 6/30/2011

 

Gross expense ratio: 1.93%   Performance data quoted represents past performance; past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the fund may be lower or higher than the performance quoted. Performance current to the most recent month end may be obtained by calling 866-455-3863 or visiting our Performance page. Performance data shown does not reflect the 2.00% redemption fee imposed on shares redeemed within 30 days. If it did, total returns would be reduced.

Important Disclosures

  • Small- and medium-capitalization companies tend to have limited liquidity and greater price volatility than large-capitalization companies.
  • Investments in foreign securities involve greater volatility and political, economic and currency risks and differences in accounting methods.
  • Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities.
  • ETF Trading Risk – Because the funds invest in ETFs, they are subject to additional risks that do not apply to conventional mutual funds, including the risks that the market price of an ETF’s shares may trade at a discount to its net asset value ("NAV"), an active secondary trading market may not develop or be maintained, or trading may be halted by the exchange in which they trade, which may impact a Fund’s ability to sell its shares.

Any tax or legal information provided is merely a summary of our understanding and interpretation of some of the current income tax regulations and is not exhaustive. Investors must consult their tax advisor or legal counsel for advice and information concerning their particular situation. Neither the Fund nor any of its representatives may give legal or tax advice. After-tax returns are calculated using the historical highest individual federal marginal income tax rates and do not reflect the impact of state and local taxes. Actual after-tax returns depend on your situation and may differ from those shown, and  after-tax returns are not relevant to investors who hold their shares through tax-deferred arrangements such as 401(k) plans or IRA. Remember, the Fund’s past performance, before and after taxes, is not necessarily how the Fund will perform in the future.

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