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Tax Aware Investors Will Get New Option


Investors who want to minimize taxes do not necessarily have to abandon actively-managed equity products for tax-free or exchange- traded funds.

Earlier this month, J.P. Morgan announced plans to introduce a fourth tax-aware' fund, the J.P. Morgan Tax Aware Small Company Opportunities Fund. The SEC is likely to approve the fund this week, according to the company. J.P. Morgan maintains that its product addresses investors' heightened tax concerns while being responsive to their

desire for actively-managed portfolios. Consequently, it will be successful despite the recent attention given to tax efficient exchange-traded funds, the company said.

The new product is a no-load, small-cap fund and will use a tax-sensitive optimization model developed by J.P. Morgan to try to minimize capital gains.

"The fund sells securities when the anticipated performance benefit justifies the resulting tax liability," according to the fund's prospectus. "This strategy often includes holding securities long enough to avoid higher, short-term capital-gains taxes, selling shares with a higher cost basis first, and offsetting gains realized in one security by selling another security at a capital loss."

The strategy finds a middle ground between active management and a buy and hold' strategy, said Marion Pardo, managing director and head of the small-cap equity group at J.P. Morgan. This is one of the advantages this type of product has over exchange-traded funds, which although very different products, have been successful, in part, because of their tax advantages, said Christopher Traulsen, a senior analyst at Morningstar of Chicago.

"Exchange-traded fund are passive strategies," said George Gatch, managing director and head of J.P. Morgan's mutual fund business. "This fund is designed for people who are tax aware and want the expertise of a professionally-managed portfolio."

"Yes, ETFs will compete with it, but this one offers active management, which right now, ETFs do not," said Traulsen.

"It'll be competitive with ETFs to some extent, but there are probably going to be more factors in determining its success than just how it does against ETFs," said Jim Folwell, a consultant with Cerulli Associates of Boston. One advantage the product has is that advisers can justify charging a fee more easily than with an ETF, said Folwell.

An actively-managed product could substantially increase a fund's tax efficiency because of its flexibility compared to an index-type fund, according to Traulsen.

"With a small-cap index, if a company has success and becomes too large, it'll be rolled out of the index and capital gains will be realized, whereas an actively-managed small-cap fund wouldn't have to do it," he said.

"Stocks become candidates for sale when they appear overvalued or when the company is no longer a small-cap company, but the fund may also continue to hold them if it believes further substantial growth is possible," the fund's prospectus says.

This product is timely because of an increased investor sensitivity to taxes, according to J.P. Morgan executives.

"This is becoming an increasingly important issue for all investors," said Gatch. "In fact, Morningstar [of Chicago] has recently added a data point of tax efficiency on their database...the SEC has released guidelines [for] providing after-tax returns to mutual fund shareholders."

"Why does [tax awareness] matter more now than ever? Because the individual investor has changed," said Benjamin Thompson, vice president and portfolio manager at J.P. Morgan. "The individual investor's sophistication is different now than it was five years ago. Their consciousness about portfolio theory, portfolio construction, and security analysis is different and it's better. They're more cost conscious, they're looking at fees, and they're looking at commissions. Also, the information availability is significantly greater than it was a couple of years ago."

Another reason tax awareness is heightened is the increased volatility of the market.

"One of the things...that's extremely important this year is making sure that if you're in a volatile time and you've got down or flat returns for the year, that you're also not getting a big tax bill on top of it," said Terry Banet, senior portfolio manager for private equity and balanced accounts at J.P. Morgan and manager of its Tax Aware U.S. Equity Fund.

"I think you see an increasing interest by the financial planning community," said Pardo. "If you think about the kinds of markets we've been in for the past three or five years, it's basically been a kind of buy-and-hold market, uni-directional. [There has been] a great deal of volatility, but basically [the market has been] up, so that even if you weren't trying to, if you were a mutual fund manager dealing with momentum, you probably ended up pretty tax efficient in the sense that you didn't sell anything and just held on to your winners. I've been sort of wondering if we have an illusion of tax efficiency out there when you look at the tax efficiency on some of these mutual funds, which have been a bi-product of nobody selling anything...I think this year you're going to start to see some of the effects of that."

"If they weren't tax sensitive up until now, investors will be tax sensitive going forward," said Gatch.