Mutual fund investors have had a rough few months. But if the market doesn't do a quick turnaround, they are really going to be miserable come December. Not only will their funds have gone south, they'll also get hit with heavy taxes on the capital gains the funds have paid shareholders. Notes Milwaukee-based financial planner Paula Hogan: "This is the first time many people are going to face losses and get distributed gains."
We're not talking about profits generated when you sell shares in a fund. Rather,these are gains earned by the fund when it trades stocks in its portfolio. How can you suffer a loss and owe capital-gains taxes at the same time? When funds sell assets, they're required to pass any gains or losses to shareholders. And many funds, especially those whose investors are running for the exits, have had to cash in holdings over the past month to raise money for redemptions.
Say your fund bought 10,000 shares of XYZ Corp. in '96 for $30 apiece. By the start of this year, XYZ had climbed to $75. Then the market slumped, and your manager bailed out last week at $50. That locked in a $250,000 drop in the fund's '98 returns. But it also generated a $200,000 capital gain. By yearend, that money must be distributed to fund shareholders, who then owe a 20% tax. Those who reinvest distributions rather than taking them in cash will owe tax on money they don't actually have.
This is the same tax trap investors fell into back in '87, the last time the market took a big hit. According to Morningstar, at least 50 funds lost money that year but paid out capital gains exceeding 14% of assets. Fidelity Select Brokerage & Investment Fund lost almost 37% but had to pay out a 15% capital-gains distribution. To John Rekenthaler, director of research for Morningstar, 1998 is an eerie replay of '87. "When you have gains in the first half of the year and the market falls in the second--that's when you get killed," he says.
While it's too soon to tell how widespread the tax problem will be, it's not hard to find the traps. Small-cap funds, especially those investing in tech stocks, were red-hot through the first quarter. But the past six months have been a nightmare, and the average small-cap fund is down 20% for the year. The same goes for funds investing in banks. And Latin America funds? As their prices have plunged and redemptions have mounted, they've had to sell stocks they bought cheaply years ago.
What can you do? Before you invest, shun funds with high turnover rates--some aggressive managers may roll over their entire portfolio in a year like this. You can find a fund's turnover rate in its annual report or on Web sites such as www.businessweek.com or www.morningstar.com.
Be leery of managers who suddenly shift investment philosophies. In today's down market, that's a classic recipe for negative returns and big distributed gains. Also look to see whether a fund is holding a bundle of unrealized gains. That's tougher to find, but the fund's annual report will give you clues. Or call a fund and ask before you invest. It can be a tip-off that you may be hit with a distribution in December.
CASH OUT? Index funds are less likely to produce big tax hits, as are funds that are managed with an eye toward keeping distributions--and capital-gains tax liabilities--low. You can control the timing of gains by investing in Standard & Poor's Depositary Receipts (SPDRs) or World Equity Benchmark Shares (WEBS). Sold on the American Stock Exchange, they mimic U.S. and global index funds but trade like stocks.
If you still expect to be hammered, you can always cash out before your funds make their distributions in December. But many advisers are wary of swapping merely to save a few bucks in taxes. "Just because a fund manager has gains, that's no reason to fire him," says planner Joel Ticknor in Reston, Va. Besides, there is a silver lining to getting hit with gains now. If you take them in cash, you'll have some dough to slip into a money fund until the storm passes. And any distributions you get now will lower your tax bite once you do sell your shares.