NEW YORK (TheStreet) -- Taxes can infuriate mutual fund investors. Some investors get socked with tax bills nearly every year, including times when funds suffer losses.
But now because of peculiar conditions, some top-performing mutual funds offer important tax shelters. Even if the stock market climbs for the next several years, shareholders could be protected from taxes. The tax advantages are so compelling that investors who normally buy individual stocks may prefer conventional mutual funds.
To appreciate how the tax holiday has occurred, consider that shareholders can owe capital gains taxes any time a manager sells appreciated stock. But gains can be offset by trading losses. When losses equal gains, the shareholder owes no tax.
If a mutual fund has more than enough losses to offset gains during a year, the manager can store the losses, carrying them forward to use in the future. At the moment, many mutual funds have sizable stockpiles of losses left over from the downturn of 2008. The losses are so great that many shareholders aren't likely to face capital-gains tax bills for years.
To determine the tax status of mutual funds, Morningstar recently studied what it calls potential capital-gains exposure. Say a fund has stockpiled losses equal to 10% of its assets. Morningstar says that the fund has potential capital gains exposure of minus 10%. The average large-growth fund has potential gains exposure of minus 37%. In other words, the funds would have to book gains of 37% before the losses would be exhausted and shareholders would face tax bills.
The stockpiled losses are particularly intriguing now because tax rates are likely to rise next year. That will make shelters more valuable.
Should you buy a fund just because it has stockpiled losses? Hardly. Some poor-performing funds have generated losses for years. Instead, you should consider funds with strong records. If two funds have equal records, pick the one with the more promising tax outlook. Keep in mind that a good fund may have what's called a tax-loss carryforward because of a single difficult year or unusual circumstances.
, a large-growth fund that has returned 7.5% annually during the past five years, outdoing 94% of its competitors. The fund buys stocks that can grow over the long term. Holdings include software giant
. In 2008, the fund sank into the red. That created capital losses and potential gains exposure of minus 45%.
Another promising fund with a sound tax shelter is
. Before Nick Thakore took the helm in late 2008, Voyager had been producing dismal returns for years. Buying growth stocks selling at modest prices, Thakore has turned around results. Holdings include
. In 2009, Voyager returned 64%, 28 percentage points ahead of its average large-growth peer. Now the fund boasts a stellar recent record, outdoing 99% of its competitors during the past three years. The losses of earlier years have left Voyager with a potential capital-gains exposure of minus 53%.
Suppose you want to place a bet on technology. You could buy individual stocks. But if you sell them at appreciated prices, you will owe taxes. A more efficient approach could be to buy a technology fund with loss carryforwards. An interesting choice is
, which has a capital-gains exposure of minus 20%. The fund holds companies with growing earnings, including software maker
Columbia got clobbered in 2008 when it lost 51%. Despite that bad year, the mutual fund has returned 8.4% annually during the past five years, outdoing 53% of competitors.
Loomis Sayles Small Cap Growth
has an intriguing capital-gains exposure of minus 159%. The losses are connected to a dismal long-term record. During the past 10 years, the mutual fund lost 6.3% annually, lagging behind 97% of its small-growth peers.
But things have brightened since a new team took over in 2005. During the past five years, the fund returned 8% annually, outdoing 84% of small-growth funds. The fund takes growth stocks with strong balance sheets and modest prices. Holdings include medical-device maker
( BBBB), which produces educational software.
Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.