Embedded capital losses, which represent a combination of realized and unrealized losses, offer a rare opportunity for mutual fund investors in taxable accounts. According to Morningstar Inc., there are more 100 equity funds with embedded losses, also known as tax-loss overhangs, of more than 100%.
In other words, a fund with a 100% tax-loss overhang could double in size without paying out a capital gains or income distribution that would be subject to tax.
There are 41 funds with overhangs of more than 200%, including five with overhangs of more than 700%.
“It's the only good thing that comes out of a
bear market, and it's an important thing to pay attention to,” said Herb Morgan, chief investment officer of Efficient Market Advisors LLC, which has $140 million under advisement.
A fund's tax-loss overhang should never be used as an initial screen or primary reason for investing in a mutual fund. But if a particular fund meets other criteria related to such factors as fees, strategy, track record and management, the tax-loss overhang can be a huge advantage — especially in an environment that is likely to see higher taxes across the board.
“It's important to remember that the only way for a fund to get a huge tax-loss carry-forward is to lose a lot of money, so you don't want to let the tax tail wag the dog,” said Morningstar analyst Christopher Davis. “If you're just looking at the tax benefits, you should realize that the most tax-efficient fund would be one that loses 10% every year, but that's not really what most investors want in a mutual fund.”
Unlike capital gains and income distributions, which mutual funds are required to pass through annually to shareholders, losses can't be passed through to shareholders. But those losses, once realized through the sale of a security, can be used to offset a fund's distributions from investment gains.
The losses can also be carried forward for up to eight years.
Despite the benefits for investors, mutual fund companies are loath to promote or even openly discuss the potential tax losses inside the funds.
One reason for the reluctance by the fund industry to promote the embedded losses boils down to the awkwardness of drawing attention to built-up losses, which often reflect poor investment performance but can also reflect forced selling due to investor redemptions.
The other primary reason that fund companies aren't talking about sizable carried losses is that new investors in a fund will dilute the benefits of the losses for existing shareholders, many of whom actually suffered through the periods that led to the embedded losses.
Of course, the opposite is true for positive capital gains exposure, and investors in taxable accounts should always be aware of a fund's potential for a big year-end distribution before investing in a fund.
HELPFUL DATA POINT
Some analysts describe the potential capital gains exposure, whether positive or negative, as one of the best forward-looking data points available.
“It gives investors an idea of what is on the books and what the potential tax-loss carry-forward is,” said Tom Roseen, a research manager at Lipper Inc.
Morningstar's data illustrate the potential tax consequences in the event that every position in the fund is liquidated, which is an unlikely scenario but does provide a good sense of pent-up losses that could be realized and provide tax advantages.
Morningstar updates each fund's potential capital gains exposure monthly based on the size of the fund, but the numerator in the equation is based on each fund's most recent filing with the Securities and Exchange Commission.
Each fund's potential capital gains exposure is listed on Morningstar's website and can also be found in the notes section of the income statement in a fund's annual report.
CATALYST IS KEY
Although there might be a tendency to shy away from funds with the stigma of large tax-loss overhangs, the key is finding funds where there is a catalyst, such as a manager change, to generate some positive performance.
For example, Putnam Voyager (PVOYX) has a potential tax-loss overhang of 55%, but the $3.9 billion fund has seen a major performance boost since November 2008 when Nicholas Thakore took over management.
Last year, the Putnam Investments large-cap fund gained 64%, which compares with a 26% gain by the S&P 500.
This year through last Tuesday, the fund was up 10%, and the index was up 6%.
A more extreme example is the $370,000 Apex Mid Cap Growth Fund (BMCGX), which has a potential tax-loss overhang of 803%.
The fund, managed since its 1992 inception by Suresh Bhirud, president of Bhirud Associates Inc., gained 22.5% last year and 22.4% this year through last Tuesday.
“Once you've decided it's a good fund, dig into the annual report to find out how big the tax-loss carry-forward is,” Mr. Roseen said. “This is a chance for investors to come in and benefit from the disastrous events of 2008.”
Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected].
