It's no surprise that most investors want to pay lower taxes. They may want to minimize their taxes, maximize their after-tax returns or some combination of both. To meet those investors' needs, there has been a proliferation of tax-managed mutual funds.

Five years ago, there were seven tax-managed mutual funds; today there are more than 65. After maximizing their contributions to tax-deferred or qualified accounts, many investors are turning to tax-managed mutual funds.

All tax-managed funds, however, are not created equal. Many funds that have low portfolio turnover claim to be tax managed or tax efficient. While these funds might succeed in cutting "realized" capital gains, they do not address a huge, potential hazard - "unrealized" capital gains. These gains can build in a fund over time; this is a normal event for shareholders who invest in a fund over time. Newer investors, however, can be saddled with a huge tax liability without having enjoyed the benefits of the investment gains. For this reason, index funds, which are often thought to be tax efficient, are not. Unrealized capital gains make up a large percentage of many S&P 500 funds' assets.

One way to combat unrealized capital gains is to serialize a fund, closing it when it hits a certain level of unrealized capital-gains exposure. A fund could close, for example, if the unrealized capital gains exposure hit 25 percent. A new fund with the same management and approach would be started, and, at the outset, the new fund would have no unrealized capital gains. This serialization feature would help insulate new investors.

No matter how tax-efficient a fund might be, investors are not going to make money unless the fund manager can deliver strong pretax returns. A well-managed, truly tax-efficient fund will concentrate on stock selection, regard portfolio turnover, incorporate a strategy concerning the sale of high-cost basis stock, and address the issue of unrealized capital gains.

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