The greatest source of tax efficiency in mutual funds is popularity.

I came to that conclusion after several readers wrote asking how much the portfolio turnover rate of a mutual fund affected it's after-tax return--- a topic on many investors minds after they lost money during last year but received hefty distributions of taxable capital gains.

If this is all Greek to you, don't feel badly. It's an arcane subject but one of vital importance to your long-term return.

Let's start by imagining that you have a choice of three portfolios, all getting equal pre-tax returns but with different portfolio turnover rates.

• The first fund enjoys a 20 percent annual return and never sells anything. Like Warren Buffett, the ideal holding period for this manager is "forever." This fund has a long-term return of 20 percent so your money will double in about 3.5 years.

• The second fund also enjoys a 20 percent annual return but sells each stock after it has been held a year. As a result, you'll get an annual distribution that will cause you to pay taxes on a long-term capital gain. You'll get to keep 80 percent of your return, or 16 percent. This fund has a long-term return of 16 percent so it will take about 4.5 years for your money to double.

• The third fund enjoys a 20 percent annual return as well but achieves it with short term trading. That makes all the gains taxable as ordinary income. If you are an investor in the 39 percent tax bracket this means your net return will be just over 12 percent, which means that you'll need about 6 years to double your money.

As you can see, tax efficiency means something. Studies have regularly shown that a fund may rank among the highest before taxes but can rank much lower after taxes are considered. Over the 5-year period ending January 31, for instance, the Vanguard Index 500 fund provided a pre-tax compound annual return of 18.34 percent and an after-tax return of 17.56 percent. In a search, I found 42 funds in the same category that had better pre-tax returns but poorer after-tax returns. At the far extreme, PIMCO Growth and Income Institutional shares returned 26.78 percent before taxes but only 15.99 percent after taxes. Similarly, Waddell and Reed Accumulation fund A shares, with a turnover rate of 342 percent according to Morningstar, returned 20.86 percent before taxes but only 13.67 percent after taxes.

So taxes matter. And so does turnover.

As a general rule, you and I should look for funds that have relatively low turnover rates if we are investing in a taxable account. We should do this because the pre-tax return, on average, tends to be higher in low turnover funds. Add the burden of taxes and the spread only widens. In the table below, I have calculated the results for 863 domestic equity funds Morningstar categorizes as "large blends", meaning that they represent a broad mix of large capitalization stocks. While high turnover funds have unrealized potential losses, unrealized capital gains rise as turnover declines--- that's tax efficiency.

High Turnover Reduces Tax Efficiency

Fund Group 12 mos. 3 years 5 years 10 years Turnover Potential Capital Gains
Turnover greater than 95% -0.33% 10.56% 15.83% 14.38% 271% -7%
Large Blend Average -0.28 11.41 15.98 15.42 95 11%
Turnover less than 95% -0.27 11.65 15.99 15.65 40 17%
Vanguard 500 Index -0.84 13.13 18.34 17.26 6 43%

Source: Morningstar Principia, January 31, 2001 data

Ironically, there is another source of tax efficiency. It is completely unrelated to actual portfolio turnover. A fund with a high return will attract a great deal of new investment money. That, in turn, will continuously dilute the unrealized capital gains for the earlier shareholders. You can understand this by considering a simple example.

Suppose you buy 10,000 shares in a $100 million fund priced at $10 a share, with 10 million shares outstanding. The fund has no unrealized capital gains when you invest. Your total investment will be $100,000 and you will have no unrealized capital gains in your new investment.

By the end of the first year the funds value per share doubles to $20. This means the fund is now worth $200 million and your investment is worth $200,000. The fund has an unrealized capital gain of $100 million and you have an unrealized capital gain of $100,000. The unrealized gain, in both cases, is 100 percent of the original investment. If the fund realized all gains and distributed them, you would receive a capital gains distribution of $10 a share.

But other investors are so excited by the 100 percent return that they rush to buy shares, adding an additional $800 million in new cash. The number of shares grows by 40 million to 50 million. As a consequence, the total value of the fund rises to $1 billion while the unrealized capital gains remain at $100 million. So they are only 10 percent of the funds total value.

The portfolio manager gets nervous and decides to liquidate all stock holdings, realizing $100 million in capital gains. Spread over the 50 million shares, the gain comes to $2 a share, magically reducing your tax liability. (Of course, those who put money in after you will experience the reverse, a taxable gain they never experienced.)

Far fetched, you say.

Not hardly.

One of the prime sources of apparent tax efficiency for big major funds in the last five and ten years has been asset growth from new shareholder investment. Vanguard Index 500 fund, for instance, had $17.3 billion in assets 5 years ago and would have grown to about $40.3 billion without new investment. Instead, it's got $89.4 billion in assets. As a consequence, its fundamental tax efficiency has been multiplied for long-term shareholders.

Investment success breeds tax efficiency success.