Warburg's Japan Funds Plan the Mothra of All Tax Hits

Two Warburg Pincus Japan funds will distribute huge taxable capital gains Monday.

At the close of business, the New York-based shop will distribute outsize capital gains to shareholders of the (WPJPX Quote)Warburg Pincus Japan Small Company and the (WPJGX Quote)Warburg Pincus Japan Growth funds, as well as the "Advisor" version of each fund. The gains are equal to some 55% and 22% of the funds' NAVs, or net asset value, according to company officials. Capital-gains distributions, which are taxable, are considered big when they're around 10% of a fund's NAV. NAV is the value of one of the fund's shares.

"This is enormous," says Morningstar senior fund analyst Scott Cooley. "At 10%, we start taking notice. At 20% it's large and at 50% we break out the record books. In the years that Morningstar has been covering funds, which goes back to 1984, there have only been six bigger distributions."

The Japan Small Company and Advisor Japan Small Company funds paid $7.88 and $7.82, respectively per share, to those who owned shares as of last Friday. The Japan Growth and Advisor Japan Growth funds paid $3.64 and $3.61 per share on Monday, according to company spokeswoman Leslie Mayock. The firm usually distributes capital gains in December, but it's distributing this one early to give investors time to plan for tax ramifications.

For most investors the gain will add up to a significant tax bill, according to tax pros. Based on the standard 20% capital-gains tax rate, most shareholders with 1,000 shares of Japan Small Company will face a more than $1,500 bill. The average investor holding 1,000 shares of Japan Growth will owe a bit over $700.

The massive gain appears to be a classic case of what can happen when hot funds draw a lot of money after they've posted huge performance numbers, only to have investors leave in droves when they cool down: Those who don't sell their shares often get saddled with a big tax bill.

"It's the result of two things that happened last year. First, really amazing performance last year; and second, in the beginning of this year the Japanese market slowing down. Many redemptions occurred and to meet those redemptions managers had to sell [stocks], which locked in capital gains," says Linda Moore, Warburg Pincus' director of product management.

The Japan Small Company and Japan Growth funds were two of last year's hottest performers, riding big technology and telecommunications bets to stunning 329% and 266% gains in 1999, respectively. But this year that tech/telecom focus has been their undoing, with both funds losing more than 44% since Jan. 1, according to Morningstar.

Many investors who charged in during 1999 have sold their shares during the funds' steep plummets this year. At the end of 1999 Japan Small Company had $1.1 billion in assets and Japan Growth had $836 million. At the end of July, due to sagging performance and redemptions, they had $257 million and $234 million, respectively, according to Morningstar.

Redemption fees -- charges on sales of shares held only for a few months -- can discourage quick trigger fingers, but that didn't work in this case. In May the firm upped Small Company's redemption fee on shares sold within six months of purchase from 1% to 2%, and slapped a 2% redemption fee on Japan Growth.

Before this distribution, both funds had earned above-average tax-efficiency marks from Morningstar relative to their peers.