When mutual funds sell appreciated stock, the law requires them to distribute their net capital gains to shareholders. Last year near this time, such payouts amounted to nearly 10% of the average equity fund's assets, the result of taking profits built up during the bull market. That rankled shareholders, who found themselves with huge tax liabilities even though their funds were falling in value. This year, most funds are swimming in losses, but the law doesn't allow the funds to distribute them. Instead, they remain on the funds' books and can be used only to offset future gains.
Out of this inequity in the tax law springs an opportunity. If you're investing with taxable money--not your IRA or 401(k) accounts--you should seek funds with good long-term records that have lots of red ink on their books. That way, as the fund rises again, the portfolio manager can apply those accumulated losses to offset future gains. For instance, the $380 million Pin Oak Aggressive Stock Fund has more than $770 million in losses right now. As a result, manager James Oelschlager doesn't "expect to pay any capital gains for several years."
The bear market has left no shortage of red ink. According to Standard & Poor's, 2,568 of 3,363 equity funds--76.4%--now have accumulated losses. Those losses can act as tax shelters. How? Consider the Firsthand Technology Value Fund. According to its June 30 semiannual report, the fund had accumulated over $2 billion in capital losses from the tech crash. Provided tech stocks recover--and this is one of the better investors in the sector--portfolio manager Kevin Landis will be able to run up $2 billion in realized gains before he must make another distribution. (Such sheltering doesn't eliminate your tax liability if you happen to sell fund shares at a higher price than you purchased them.)
TECH, AGAIN. Of course, you don't want to buy a fund that's inappropriate for you just because it may shelter you from taxes. "There's no question that some people will be looking for funds for tax purposes," says Harold Evensky, a Coral Gables (Fla.) financial planner. "That could be a big mistake if they wind up in volatile sector funds or funds with bad managers." The key is to find a good fund with losses that fits your overall portfolio.
The biggest losses are in the technology and telecom funds. So, one strategy would be to identify the best funds of the battered lot. Dresdner RCM Global Technology, Fidelity Select Developing Communications, and Firsthand Technology Value all have losses at least as great as their assets (table). "Even in an optimistic market, it will probably take at least two to three years of gains to cover our losses," says Walter Price, portfolio manager of Dresdner RCM Global Technology.
Some good diversified funds also have sizable losses. Harbor Capital Appreciation, Janus Mercury, and Van Kampen Emerging Growth, all hurt badly in the bear market, are still highly rated growth funds and should do well when that sector revives. "The fund can rise about 70% from here without incurring any tax liability," says Janus Mercury manager Warren Lammert. With over $5 billion in realized and unrealized losses, it's unlikely that new money invested in Mercury will dull its tax edge.
If you want to cast a wide net to find funds that have lots of tax-sheltering potential, it pays to subscribe to the premium service at www.morningstar.com for $99 a year. Go to the "Premium Fund Selector." Under "Set Criteria," select "Tax Analysis," and set "Potential Capital Gains Exposure" to less than zero. Then select "Morningstar Ratings" and set "Category Rating" to greater than or equal to four. That ensures that the fund has losses on its books, yet is still beating the risk-adjusted return of its peers in its fund category, be it large-cap growth, foreign stocks, technology or any other.
Don't stop there. Capital loss data are often outdated because funds are required to report them only twice a year. So you should make sure the funds have losses this year--not a problem in the current market. Select "Performance" and set "YTD Total Return" to less than zero. Negative returns mean the capital loss is probably larger than the last reported number. You also want the fund to be large enough that an influx of new money from investors doesn't substantially dilute the pool of losses. So select "Portfolio Stats," and set "Net Assets" to greater than $100 million.
TAX CODE. The type of loss is also important to your analysis, as some are more effective shelters than others. The kind that Standard & Poor's and Morningstar report are unrealized losses, which means a manager has held onto his losing positions. That shields the funds from future gains in only the losing positions. Yet if the manager sells his losers, he has a "realized loss." Realized losses can counteract gains anywhere in the portfolio for up to eight years after the sale. You can find this loss data in fund semiannual reports.
To view semiannual reports, scan the fund company's Web site first. If you can't find them there, check www.freeEDGAR.com. At freeEDGAR.com, plug in the fund company's name (such as Fidelity or Janus) and look for the latest reports labeled N-30D. Usually, the relevant data are in the fund's "Statement of Assets and Liabilities," which is similar to a corporate balance sheet. Occasionally, however, funds include it only in a footnote. Some fund companies will give you even more up-to-date information if you call. For instance, Vanguard Funds' phone reps provide loss data as of the end of the prior month.
What if you already own one of these funds full of tax losses? If your shares are worth less than what you paid for them, sell them and buy another loss-laden fund with a similar investment style. This way you can claim the loss in your fund shares as a tax write-off, yet still remain invested in the same type of stocks. If you like the old fund, the tax code permits you to buy it back 31 days after the sale and still get the write-off. If you've owned the fund shares long enough to still have a profit, it might be better to hold your position--and even add new money to that fund.
These tax shelters will eventually dissipate as the market recovers. So if you're really investing for the long term, find a tax-efficient fund with big losses. (A tax-efficient fund is one that takes steps to minimize having to make capital-gains distributions.) That way, once the funds have run through their losses, they'll still be managed with aftertax returns in mind. Such funds include Vanguard Tax-Managed International or T. Rowe Price Tax-Efficient Multi-Cap Growth, which have accumulated losses.
Such losses are a sore point with longtime shareholders. For new investors, however, they can make a stock market recovery a little bit sweeter.
By Lewis Braham