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Wall Street Journal, August 24, 2001


Stock Losses May Make Tax Time Less Taxing

By Theo Francis

The Wall Street Journal

C1

Finally, mutual-fund investors are getting some good news -- or at least what passes for good news these days.

Sure, portfolio performance has stunk this year for many stock-fund investors. But look at the bright side: At least fewer mutual funds are dishing out taxable capital-gains distributions. It is a predicament considerably better than what faced many fund investors a year ago. Then, investors in stock funds were bracing for a double whammy: a record wave of capital-gains distributions on top of mounting investment losses.

"It's looking a little better than last year," says Joel Dickson, a tax-efficiency expert with the Vanguard Group. This year, "there just aren't as many gains to be distributed."

You have to take what you can get in a tough market, it seems. The average diversified U.S. stock fund has fallen 11.3% this year through Wednesday, but because there are fewer capital gains -- and because more capital losses are available to offset the taxable gains -- the tax bite doesn't loom as large.

At this point last year, more than 650 U.S. diversified funds had already handed shareholders capital-gains distributions, averaging 4.4% of their net assets. So far this year, just 441 have done so, and the average distribution amounts to about half last year's average, at 2.4% of assets.

For context, fund investors absorbed a record $325 billion in capital-gains distributions last year, with $99 billion going to households holding shares in taxable accounts, according to figures from the Investment Company Institute, a fund-industry trade group. At the same time, the average stock fund fell 4.51% in 2000.

Capital gains are a tricky subject, but paying attention to them can be well worth the time of fund investors, especially those holding shares outside of Individual Retirement Accounts, 401(k) plans and other tax-deferred plans. The underlying calculus is straightforward:

As portfolio managers sell securities that have risen in value, funds incur capital gains. Losses can be used to offset those gains, but if gains exceed losses from similar sales during the year, the fund must distribute the excess to its shareholders or else incur stiffer taxes. For investors without tax-deferred accounts, such distributions are taxable, even if the fund holder reinvests the money into the fund.

Funds can't distribute the losses, but managers can use them to offset gains for tax purposes for as long as eight more years, thus cutting the risk of future gains distributions. And today, hundreds of funds show the potential for realizing big losses to offset future gains, according to data from Morningstar Inc., the Chicago fund tracker. For example, its figures show the Scudder Small CapValue Fund, up 14.81% year-to-date, with unrealized losses equal to 13% of the fund's assets.

That makes it worthwhile for taxable investors to keep an eye on a fund's ability to carry losses forward on its tax returns, says Mark Balasa, president of Schaumburg, Ill., investment adviser Balasa & Hoffman Inc. For those investing in a taxable account, "this would be one of the top five considerations in terms of selecting a fund," Mr. Balasa says. "You've given yourself this embedded cushion, if you will, against distributions for some block of time."

Determining a fund's distribution prospects isn't that difficult. Funds provide a history of distributions and list unrealized gains or losses in their financial statements, usually toward the back of annual reports. Morningstar's Web site offers an estimate of net realized and unrealized capital gains -- negative figures are net-loss estimates -- and many fund companies provide callers with realized gain and loss figures.

Of course, for investors to benefit at tax time, the losses must be realized, which occurs when the fund manager sells portfolio losers. Even funds with plenty of potential losses can end up making big gains distributions if managers sell winners only, notes Vanguard's Mr. Dickson. The best way to tell whether a manager is likely to make tax issues a priority is to read the fund's prospectus, which outlines its operating goals. "Pay attention to whether [the] fund is being managed for after-tax returns," he says.

One study suggests that fund managers do keep an eye on tax consequences from their sales, even if the fund's prospectus doesn't require it. Fund managers, particularly at growth funds that focus on the stocks of rapidly expanding companies, were less likely to sell a security the larger the resulting capital gain became, says Steven Huddart, co-author of the study and associate accounting professor at Pennsylvania State University's Smeal College of Business. Funds also tend to be consistent, Prof. Huddart says. "A fund that was less likely to trigger large gains in one year is also less likely to trigger large gains in subsequent years," he says.

Charles Rinaldi says he considers tax consequences when selling securities in the two Strong Capital Management funds he manages, even though he isn't obliged to. "It's something we look at every month, to see if we can harvest any losses," says Mr. Rinaldi, who runs the Strong Multi-Cap Value Fund, which carries realized losses equal to more than 20% of total assets. He has run that fund for only a few months, but he says the Strong Advisor Small Cap Value Fund, which he has run since its inception, hasn't made a distribution in its four-year history.

"There are a lot of different things you can do without sacrificing performance," Mr. Rinaldi says. For example, because loss and gain calculations can be made according to each stock lot -- or group of shares bought at the same time -- managers can buy more of a stock during a price slide; later, by selling higher-priced lots of that stock at a loss, the manager can reap tax losses to offset gains from other securities. Such maneuvers make the most sense if the manager is sure that the stock price will recover, and some restrictions apply, including a tax rule wiping away the tax advantages if sellers repurchase a security within a month of selling it.

Mr. Rinaldi's Multi-Cap Value Fund illustrates the benefits of tax losses, too. Because it accumulated hefty realized losses after Mr. Rinaldi took over, "there probably won't be a distribution for the next couple years," he says. "But I can't guarantee that."

On the heels of last year's hefty capital-gains distributions, fund-complex executives will likely encourage managers to avoid distributions whenever practical, says Mark Seferovich, who runs the W&R Small Cap Growth Fund. Selling losers doesn't depress a fund's net asset value, so it often makes sense.

Still, fund investors shouldn't lose sight of the big picture when selecting funds, says Phillip N. Davidson, portfolio manager of the American Century Value and Equity Income funds. The idea is to pick a fund with solid management and a good track record whose investment strategy and risk-taking suits an investor's needs.

Knowing the net unrealized losses available, managers might make a useful tie-breaker for an investor deciding between two equally desirable funds, Mr. Davidson argues. Beyond that, "it's hard to game [tax losses] to your advantage."


Steven Huddart
Smeal College of Business, Penn State University, University Park, PA 16802-3603 USA
(814) 863-0048
huddart@psu.edu
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