Fidelity Tax Managed Stock uses several strategies to avoid generating capital-gains distributions. By Andrew Tanzer, Senior Associate Editor September 25, 2008 In a perfect world, some mutual funds would be aimed at taxable investors and others at tax-deferred investors -- that is, those with money in IRAs, 401(k) plans and the like. After all, such a dichotomy exists in the world of bond funds. Tax-exempt municipal-bond funds are ideal for investors in taxable accounts, while taxable bond funds are well suited for retirement-account holders.But that's not the way stock mutual funds work. Both investing constituencies -- taxable and tax-shielded -- are lumped together, and funds are generally run without regard for tax efficiency. In particular, funds with high turnovers that book large gains (lest you've forgotten, markets do rise from time to time) can generate painful taxable capital-gains distributions. In fact, there are tax-efficient funds aimed at taxable investors, and some, such as Fidelity Tax Managed Stock, have posted fine results. Over the past five years through August 31, Tax Managed (symbol FTXMX) returned an annualized 9.5% before tax and 9.4% after tax, good enough to beat 94% of large-company funds after tax, according to Morningstar. Note the minimal loss to taxes. Since the fund was launched in 1998, it hasn't made a single capital-gains distribution. (Keep in mind that the figures assume you don't sell the fund; if you do, you erode much of the benefit of the fund's tax-efficient focus.) Year-to-date through September 24, the fund lost 21%, trailing Standard & Poor's 500-stock index by three percentage points. Advertisement Manager Keith Quinton says his fund avoids generating taxable distribution through several common tax-management strategies. For instance, he keeps track of the cost basis of each lot of stock he purchases. He'll sell the highest-cost lot first. That may generate losses he can use to offset realized capital gains. He also strategically uses losses, which can be carried forward for up to seven years. And he'll wait until 12 months have elapsed before selling a winner so that the fund is booking a long-term tax rate (15% federal rate) instead of a short-term capital gain (taxed at up to 35% on federal taxes). Unlike most tax-managed funds, Fidelity's does not deploy a long-term buy-and-hold investment strategy. "I take a more aggressive shotgun approach," says Quinton. "I harvest losses where investments don't work and use them to shelter gains." In constructing his portfolio, Quinton says he relies on both quantitative analysis (he's a quant by background) and fundamental company analysis coming his way from Fidelity's army of 100-plus stock analysts. He concentrates his investments in stocks that show well on both screens. Some of his large holdings as of July 31 included IBM (IBM), United States Steel (X), ConocoPhillips (COP) and Abbott Labs (ABT). If you're investing money from a taxable account in a mutual fund, you may want to pay more attention to the tax efficiency of your fund. You can find historical comparisons of before- and after-tax returns of the fund in its prospectus or on Morningstar.com. And if tax rates rise after this fall's elections, you may want to pay even more attention. "The higher the tax rates, the more benefit there is to tax efficiency," says Quinton. Fidelity Tax Managed Stock charges annual expenses of 0.82%. It requires a minimum investment of $10,000 and levies a 1% redemption fee on shares held less than two years-a policy designed to discourage trading of the fund's shares, which can reduce its fund's tax efficiency.