Capital gains looming once again

Nov 5, 2007 @ 12:01 am

By David Hoffman

With corrrections Mutual fund investors will learn the hard way at the end of this year that you can never keep the tax man away for long. That is when fund companies announce taxable distributions for their funds. For some shareholders, it will be the first capital gains they will have seen since the technology bubble burst in March 2000, industry experts said. And shareholders in some of the nation's most popular funds will be affected. Big names such as the $45.35 billion Fidelity Magellan Fund, the $19.2 billion Legg Mason Value Trust Fund, the $53.8 billion Vanguard Windsor II Fund and the $26.4 billion American Funds Smallcap World Fund are expected to make distributions — exceeding 10% of net asset value in some cases. Taxable distributions are expected to be the largest since 2000, when they totaled $298.4 billion, said Tom Roseen, a Denver-based senior analyst with Lipper Inc. of New York. They may be even greater than that this year, said Duncan Richardson, a portfolio manager and chief equity investment officer for Boston-based Eaton Vance Corp. "I think it's going to be a new high-water mark," he said of this year's taxable distributions. That's partly due to the market volatility seen this year, Mr. Richardson said. Such volatility triggers trading, and the more trading, the greater the potential for funds to trigger capital gains, he said. Many investors are sure to be shocked no matter who is right. Last year, taxable distributions totaled $264.5 billion, but much of that went unnoticed by the general investing public, because it affected principally international funds, Mr. Roseen said. This year, many small-cap and value funds will have to pay out gains, potentially affecting a much greater number of shareholders, he said. Up till now, many such funds have been able to offset capital gains with losses that stemmed from the tech collapse in 2000, but many of those losses are now depleted, Mr. Roseen said. "We have been on a tax holiday," he said. But the good times are about to come to an end, Mr. Roseen said. Fund companies agree that taxable distributions will have a bigger effect this year. At T. Rowe Price Group Inc. of Baltimore, distributions are expected to be up 40% from last year's, said Sam Beardsley, a vice president and director of investment taxation. T. Rowe funds are expected to make on average a distribution equal to 5.3% of net asset value, he said. Six of its funds are expected to make distributions equal to 10% of NAV, Mr. Beardsley said.

When funds start to make distributions equal to 10% of NAV, it signals that the tax bug is back, said Christopher Davis, an analyst with Morningstar Inc. of Chicago.

"It's pretty hefty," he said.

The Vanguard Group Inc. of Malvern, Pa., expects that three of its funds — Windsor II, the $7.69 billion Vanguard Strategic Equity Fund and the $3.13 billion Vanguard International Explorer Fund — will have distributions equal or greater to 10% of NAV, said Rebecca Cohen, a company spokeswoman. In each case, the distribution would be the largest since 2000, when it was 4.8%, more than 12% and 12.29%, respectively.

Each of the three made distributions in each of the past three years.

Ms. Cohen warned not to read too much into this year's distributions for the three funds.

"Generally, Vanguard funds should have minimal distributions this year," she said. "Unfortunately, the Chicken Little story circulating about this year's mutual fund distributions might cause investors to sell shares simply to avoid taxes."

It is a valid fear, especially considering that some once-highflying funds that have fallen on hard times expect to make big distributions.

The well-respected $1.93 billion Muhlenkamp Fund, from Muhlenkamp & Co. Inc. in Wexford, Pa., has managed to avoid taxable distributions since 2000 but this year will have to make a distribution equal to 10% of the fund's NAV. It isn't an opportune time, given the fund's recent performance.

Year-to-date through September it had lost 2.60%, placing it in the 98th percentile of its large-value category, according to Morningstar.

The 3% to 4% distribution anticipated for Legg Mason Value Trust — its second this year — also comes at a bad time for the fund, which is offered by Legg Mason Inc. of Baltimore.

The fund, which made a 2% distribution in June, its first since a small one in 2001, has been struggling. Its year-to-date return through last month of 3.20% placed it in the 97th percentile of its large-blend category, according to Morningstar.

Magellan, is expected to make a 5% distribution. Last year, the flagship fund of Boston-based Fidelity Investments made a whopping distribution of 18% of NAV, reflecting the massive turnover in holdings that took place after Harry Lange replaced Robert Stansky at the helm.

While American Funds Smallcap World, offered by Capital Research and Management Co. of Los Angeles, figures to make a distribution of 9% to 11%.of NAV. It made a distribution of 1.9% of NAV in 2005, its first since 2000.

Financial advisers warn that dumping such funds based on taxable distributions would be a mistake.

For starters, tax laws are subject to change, said Stephen Gorman, president of Gorman Financial Management Inc. in Hingham, Mass.

It is possible to blunt the effect of taxable distributions through tax-loss-harvesting strategies, said James Kibler, president of Eldridge Financial Planning LLC of New York.

An investor can sell a stock, bond or mutual fund at a loss, use that loss to offset any gains and buy an exchange traded fund that corresponds to the security to maintain market exposure, he said. Investors can sell the ETF after 30 days and buy back the securities sold without violating the wash sale rule in the Internal Revenue Code.

Such strategies, however, are tricky to implement, Mr. Kibler said.

It is much more likely that investors will begin to show more interest in tax-efficient investments that can save them money next year, Mr. Roseen said.

David Hoffman can be reached at


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