When it comes to funds, investors have an abundance of metrics at their disposal to help them separate the winners from the also-rans, including expense ratio and portfolio turnover. However, for many investors, the only statistic that carries any real weight is the one that usually appears in bold face in financial publications, press releases, and slick marketing materials -- trailing returns.

'How much did I make last quarter? Last year? The past three years?'

Without a doubt, this information is important. However, keep in mind that every April we must all hand over a portion of those gains to the government in the form of taxes. And in many cases, the funds that look terrific on a pre-tax basis suddenly fall to the bottom of the heap once Uncle Sam has taken his cut.

Therefore, it stands to reason that investors should also keep close tabs on their funds' tax-efficiency ratings -- after all, what good is a high return if it gets eaten up by the taxman? In today's report, we will look at a new wave of equity-based income funds that are designed to maximize yields without running up the tax bill. And after explaining the ins and outs of these tax-advantaged funds, we'll take a detailed look at two of our favorites.

Tax Changes Favor Income Investors

As you may know, in 2003 legislation was introduced that effectively reduced the tax ceiling on dividend distributions to just 15% (from a top marginal rate of 38.6%). As expected, the move had an immediate impact, and dividends have since enjoyed a strong rise in popularity.

In fact, three-fourths of all S&P 500 firms now make regular quarterly distributions, dishing out more than $250 billion to shareholders every year -- and that doesn't include smaller firms that belong to other indexes.

However, as is usually the case, the new laws came with fine print, and many investors have found out the hard way that not all dividend income qualifies for the reduced rate. For example, payments made by real estate investment trusts (REITs) are still taxed at ordinary income tax rates of up to 35%.

Income from some foreign stocks also fails to qualify. And of course, the new laws only cover dividend income, not interest income -- so any interest generated by CDs, savings accounts, fixed annuities, bonds, and other securities remains fully taxable.

Therefore, the distributions made by most income-oriented funds -- the majority of which either invest in bonds or a broad mixture of stocks, bonds, preferred shares, and other securities -- aren't fully entitled to the tax break.

In other words, if a fund shareholder receives distributions totaling $1 per share, it's a safe bet that they might only wind up with $0.65 (assuming a regular income tax rate of 35%) or so after paying taxes. And depending on state taxes, they may keep even less than that.

Fortunately, a whole new breed of closed-end funds has cropped up with a single purpose in mind -- to maximize after-tax income by focusing almost exclusively on stocks with dividends that qualify for the reduced 15% tax rate.

Two Real-World Examples

To give you an idea of how popular these new funds have become, consider this: In 2006, Eaton Vance (a pioneer in tax-managed investing) raised $2.62 billion by launching a new tax-advantaged income fund -- the Eaton Vance Tax-Managed Diversified Equity Income Fund (NYSE: ETY).

At the time, the launch ranked as the biggest closed-end fund initial public offering (IPO) in Wall Street history. And this is just one of many of these funds now on the market.

To provide a real-world example of how these funds work, let's take a look at one: the Nuveen Tax-Advantaged Total Return Strategy Fund (NYSE: JTA). When the fund offered quarterly distributions of $0.5075 per share, for an annual payout of $2.03 per share, all of that total consisted of either qualified dividend income (QDI) or long-term capital gains -- which were both taxed at just 15%.

If the entire distribution were taxed as ordinary income at the 35% rate, then shareholders would keep only $1.32 per share, and the rest would go to Uncle Sam. But since all of the distribution qualified for the 15% dividend tax rate, investors would get to keep up to $1.73 per share of the total $2.03 distribution.

That difference may not sound like very much, but if you own 10,000 shares, the $4,100 you'll save in taxes could pay for a very nice cruise. So you can see, it literally pays to invest in tax-advantaged funds.