Their Losses, Your Gains
Investors in the $9 billion Janus Twenty Fund (JAVLX ) may well have their cake and eat it, too. Not only is it this year's top-performing large-cap growth fund, up more than 17%, but what's even sweeter is that Uncle Sam won't get his mitts on those gains for some time. Janus Twenty, like many funds nursing a nasty hangover from the tech bust, has accumulated billions of dollars in losses that it can use to offset future capital gains. The result: tax-free returns, at least for now. "The good news today for many fund investors, even for those just buying into a fund, is that they're getting a free ride on taxes for a few years," says Russel Kinnel, director of fund research for Chicago fund tracker Morningstar Inc.
Chalk it up to the vagaries of the U.S. tax code. As with stocks, mutual-fund investors trigger a capital-gains tax charge if they sell at a profit. Funds, however, come with an added twist that can wreak havoc on a taxable portfolio. They must pay out 98% of any capital gains they earn when selling stocks in their portfolios. Investors then must pay taxes on those gains the same year -- even if they continue to hold the fund.
But many fund investors are now getting a tax holiday. Two years after the stock market pulled out of its dive, the average domestic equity fund still has capital losses -- both on stocks it has sold and those it still owns -- equal to more than 15% of its assets, according to Morningstar. That's not just because of the market's earlier sharp drop. A huge number of investors also fled poor performers, forcing the funds to sell stocks at rock-bottom prices and take big losses.
Such losses on the books are giving mutual-fund investors a rare chance to enjoy tax-deferred gains. For as long as the capital losses last, investors can buy a fund and avoid taxes on gains until they sell, just as they would with a stock. It gives investors another vehicle -- at least temporarily -- for building tax-deferred savings after they've maxed out their IRAs or 401(k)s. Taxable funds may not have the same perks, but neither do they carry such severe restrictions.
Of course, investors need to weigh other factors such as expenses, performance, and strategy in picking a fund, warns New York financial planner Gary Schatsky. Consider Fidelity Aggressive Growth Fund (FDEGX ), which has a tax loss of $13 billion -- nearly three times as much as its assets. The fund toned down its aggressive, high-octane formula. Instead of focusing on about 100 stocks in a handful of industries, it now owns more than 350 stocks and largely avoids big bets on individual secotrs. But the new manager is still unproven: The fund has risen 9.6% over the past 12 months, ranking it in the bottom half of similar funds. Says Schatsky: "Taxes should be considered in the final analysis, not as the driving force."
Losses run deepest at large-cap growth and technology funds, which got hit the hardest when the technology bubble burst. The $4.4 billion T. Rowe Price Science & Technology Fund (PRSCX ) shed 75% of its value between 2000 and 2002 and still has $5.8 billion worth of losses. "The fund can more than double without [making] a distribution," says Sam Beardsley, head of tax for T. Rowe Price Group Inc. (TROW )"It's the perfect efficiency."
Perfect, and enduring: Losses can be carried forward and applied to future gains for up to eight years. As a result, some investors may enjoy tax-free gains well into the next decade. A significant chunk of Fidelity Aggressive Growth's losses don't expire until 2011.
Not every fund is a tax-free zone, of course. Value funds, particularly those that invest in small companies, have performed well over the past five years, and many could make a distribution this year. Even so, their investors may not owe Uncle Sam very much. A study in April by fund research firm Lipper (RTRSY ) found that mutual-fund investors paid $1 billion in taxes on gains last year, compared with $15 billion in 2000, the most in at least a decade. "The distributions we've seen in the last three years are some of the lowest in a decade," says Tom Roseen, senior research analyst for Lipper. "I believe the distributions in 2004 will not be as low in recent years, but they will be very low."
Regardless of this year's payout, taxes may become less of an issue if Representative Paul Ryan (R-Wis.) gets his way. Last year he proposed legislation that would have kept mutual-fund investors from being taxed until they sold their fund shares -- as with stocks -- thus eliminating periodic capital-gains distributions. The bill, in part, got drowned out in the hullabaloo surrounding the mutual-fund scandals. But Ryan plans to submit the proposal again. "No other financial product has the same tax treatment," says Dan Crowley, head of government affairs for the Investment Company Institute, the mutual-fund industry's trade body. "We just want mutual funds to be treated like regular stocks."
A SAVVY CHOICE
Tax-conscious investors have plenty of choices. Consider top-notch small-cap blend funds FPA Perennial Fund Inc. (FPPFX ) and FPA Paramount Fund Inc. (FPRAX ) They have identical managers and holdings and sport the same three-year annualized return of 14%. Yet Paramount probably won't pay a distribution until at least 2010, while Perennial paid out $1.07 a share this year. How come? After managers Eric S. Ende and Steven R. Geist took the reins of Paramount in 2000, they sold all of its holdings and amassed some $180 million worth of capital losses while remaking the eclectic, concentrated portfolio into a diversified one like Perennial. Ende says they'll consider merging the two funds once Paramount's tax losses are used up or expire. But right now, Ende says, "the choice seems pretty straightforward" for tax-savvy investors.
The tax-free ride won't last forever. As the market has risen, mutual funds have been steadily chipping away at their mountain of losses. T. Rowe Price Science & Technology used $470 million this year to offset gains in the fund, including a $19 million profit it took on Cisco Systems. Some have used up nearly all their losses. After two years of sizzling performance, the $550 million Brandywine Blue Fund (BLUEX ) has cut its reserve of tax losses by 70%. The fund estimates that it can now realize modest gains of just 95 cents a share before it will have to resume paying out capital-gains distributions.
Still, for many investors, there's a unique opportunity. The taxman cometh, but he taketh nothing away -- just yet.
By Adrienne Carter in New York