by Josh Charlson
Last week, in Year-end Tax Traps, we discussed steps you should take to minimize the tax implications of unwanted capital-gains distributions when selling and buying mutual funds near the end of the year. One suggestion was to call your fund's customer-service line to ask whether there's a potential distribution you might need to consider. But often the fund companies can't give you information about their distributions until shortly before the record date (the date on which funds determine which shareholders are liable to receive taxable distributions). That means most investors have little time to make decisions about tax-related maneuvers. Given such uncertainty, are there ways to know in advance whether a particular fund is likely to pay out a large distribution?
In truth, there are no characteristics that can predict with precision those funds that will produce the highest year-end tax bills. But certain attributes can help alert investors to funds that are at risk of paying out big gains. By keeping a watchful eye for these danger signs in your fund investments, you can at least keep on top of those specific funds as distribution time rolls around in December.
Keeping track of your funds' tax tendencies can yield benefits for more than current circumstances; it can also boost the longer-term after-tax performance of your portfolio. Using the questions below as guidelines for assessing new investments as well as existing ones, you can identify funds whose lowered tax efficiency might put a dent in otherwise solid total returns.
Funds with high turnover rates (the average domestic equity fund has a turnover rate of around 85%) tend to produce more internally realized capital gains simply because they are selling their stocks more often. For a fast-trading fund, these gains will often be short-term (less than 12 months), which, under the new tax laws, are penalized at a higher tax rate than long-term gains. Turnover rates can be found in a fund's annual report, or in the Portfolio section of Fund Quicktakes on Morningstar.Net.
But a high turnover rate is no guarantee of poor tax efficiency. Some very-high-turnover managers (say in excess of 150%) tend to cancel out capital gains with losses, and certain managers (Ron Baron is one) consciously try to achieve such a balance. With the escalating stock market of the past few years, it's been hard to find enough losses to cancel gains, but funds with technology or Asia exposure this year should have some opportunities to do so.
Often, a new manager will make wholesale changes in a fund, resulting in a considerable amount of realized capital gains. Fidelity Magellan, for instance, paid out a big capital-gains distribution of $12.85 (approximately 16% of NAV) in 1996, after Jeff Vinik was replaced by Robert Stansky, who revamped the portfolio. This year, John Hancock Emerging Growth will be paying out a nearly 20% distribution, as reported here recently by Russ Kinnel, owing to a similar overhaul by new management.
Sometimes a painful distribution is the medicine shareholders have to take to get improvement from a managerial shift. But if you're unhappy with a fund's changes and intend to get out, by all means do so before the distribution is recorded. And prospective buyers who want to benefit from such a transformation should probably hold on to their money until the purging is complete.
A smaller pool of assets makes a fund less tax-efficient, because its gains are spread across fewer shares. The opposite is true for funds experiencing growing asset bases, where tax effects are diluted. Say you have a $100 million dollar fund with assets spread over 10 million shares at $10 per share. If that fund appreciates by 20% and realizes all of its gains, it will pay out $2 in capital gains per $10 investment; if that same fund were to lose $50 million in assets through redemptions, the taxable gain would double to $4 per share.
This phenomenon does not mean investors should race to join only the most popular funds; 1997's fund du jour may well be tomorrow's disaster. But in combination with other factors, a declining asset base can be a warning sign. In the hypothetical but hardly farfetched example of a fund that loses assets because of mediocre performance, then brings in a new manager who overhauls the portfolio, a substantial distribution could be in the offing.
More of a future indicator than a present measure, potential capital gains tell you what percentage of a fund's assets constitute unrealized capital gains that may be convertible to taxable gains. It's possible to calculate this information by combing a fund's financial statements for data such as unrealized appreciation or depreciation, realized gains or losses, and tax-loss carryforwards, but the effort is probably not worth the result. An easier solution is to phone the fund company to request the fund's average cost per share, which can be compared with your own cost per share. Not all funds may be able to provide this information, though. Finally, the information can be found in a more accessible format in Morningstar products such as Principia and Morningstar Mutual Funds, which present potential capital-gains exposure in a single percentage measurement.
It's important to recognize that knowledge that a fund carries a high degree of potential tax liability offers no guarantee about whether, or when, those gains will be realized. A fund with a consistently low turnover may build up lots of unrealized gains but rarely realize them. Ultimately, though, most funds must realize those gains at one point or another, and the savvy investor won't get blindsided by a surprise tax bill.
Unrealized capital gains can become unlocked by other events--manager changes, high turnover, strategy shifts--so it's especially important to look for combinations of the characteristics listed above. What may be innocuous in isolation can become deadly when teamed with another trait. This week, we list several more funds whose combinations of manager changes, turnover, and potential capital gains make them vulnerable to tax risks.