Tempted to buy one of those hot funds that posted big gains during the fall and winter tech run-up? Be careful. You could wind up paying for other people's gains on your tax bill.
A significant portion of last year's gains -- and the tax liability that goes with them -- may still be on the fund's books. That's because the distribution your fund makes in December typically covers only gains booked through October. Many funds, particularly those with big tech-stock bets, rose sharply in November and December. In the last two months of 1999, the tech-heavy
rose more than 37% and
TheStreet.com's Internet Index
shot up more than 51%.
If you own owned such a fund on the way up, you're merely getting taxed on gains you've earned. But if you buy one of these funds now, you could be left paying part of the tab for everyone else's prosperity.
So, this week's Saturday Screen looks for funds that might have a fair amount of these undistributed gains still in their portfolios.
Before we go further, a short primer: A fund that owns a stock that has gone up in value since its purchase has unrealized gains. When the fund sells that stock, those gains become realized. When a fund racks up more realized gains than losses, the fund is obligated to distribute them to shareholders, who then are liable for capital gains taxes on that money. Though unrealized gains represent no immediate tax threat, they are a potential one.
To make our list, a fund must have more than 70% of its portfolio invested in stocks that represent either realized or unrealized gains. The fund also has to have above-average turnover rate -- the percentage of the portfolio that has changed in the past year -- compared to its peers, because a low-turnover fund probably won't realize many gains. To ensure the turnover rate, which represents the style of the current manager, funds on our list must have a manager who has been in place at least two years.
Here's our top 10, ranked by potential capital gains exposure.
Before we start looking at these, keep in mind that this portfolio information dates back one to three months so it may have changed. Also, making our list doesn't guarantee you'll get a fat tax bill later this year. Careful managers can reduce shareholders' tax liability by carefully matching gains with losses and by selling higher-cost shares before lower-cost ones.
Then again, a high percentage of winners and a hankering for fast trading are typically a recipe for a big cap-gains distribution. And each of these funds has plenty of gains that could carry over from the end of last year. On average, they returned 71.1% in 1999, but they rose a whopping 48.3% in the fourth quarter.
"Clearly when you're looking at a fund with more than 80% (cap-gain) exposure and more than 100% turnover, you've got to think you're going to get a lot back at year-end," says
analyst Russ Kinnel.
The list is dominated by aggressive small- and mid-cap growth funds that primarily rode the TMT (tech-media-telecom stock) train to fat returns. The only large-cap fund is
Evergreen Strategic Growth.
Most funds also have gains for 2000, so they probably haven't got a slew of losers to offset their winners. But the weaker year-to-date performers on our list still are sitting on big gains.
Putnam OTC & Emerging Company, for example, gained 81% in the fourth quarter of 1999, so "even if it doesn't have much in the way of a return this year, it still might be getting ready to distribute a fair amount," says Kinnel. He adds that weaker near-term performers might make big distributions this year because they aren't drawing new investors, which would reduce the distribution by spreading it among more shareholders.
One way to figure out who on this list is most likely to stick you with a big gain, is to look at each fund's tax-efficiency track record compared with its peers.
Morningstar calculates each fund's after-tax return by assuming dividends and short-term gains are taxed at the maximum federal rate of 39.6% and long-term gains are taxed at a 20% rate.
Over the past three years
Van Kampen Emerging Growth,
RS MicroCap Growth, and
Warburg Pincus Small Company Growth
have been more tax-efficient than their average peer, according to Morningstar.
On average, shareholders in these funds have lost less than 5% of their pretax returns over the past three years to Uncle Sam.
On the flip side, shareholders in
Standish Small Cap Equity,
Evergreen Strategic Growth and
Eaton Vance Special Equity
have lost between 11% and 14% of their pretax returns to taxes over the same time period, according to Morningstar.
Keep in mind that most managers don't worry too much about tax efficiency because they're paid to focus on pretax or absolute returns. What's the big deal if you buy a fund that sticks you with a big tax bill anyway?
"If these funds are likely to distribute 20% or 30% gains on returns you didn't even make, and you get taxed on a third of that, that's a 10% drag on whatever return you get this year. If you think a 5% load is bad, think about a 10% tax bill on returns you didn't earn. You're starting pretty deep in the hole," says Kinnel.
So, before you buy a fund that was hot last year, whether it made our list or not, check out its potential capital gains by calling the fund company or doing your own research on the Web.
If a fund has a big embedded cap gain and you absolutely, positively have to own it, there's only one clear solution: Buy shares in a tax-deferred individual retirement account, or IRA. Then, no matter how big the fund's capital gains payout, the account's tax-deferred status makes it a nonissue.
Ian McDonald owns shares of the Putnam OTC & Emerging Company fund.