I have a question concerning some of the high-flying Internet mutual funds. Many are still up with strong gains; many will also have huge capital-gains distributions. When mutual funds sell a stock for a gain during the year, do they set aside the funds necessary for the distribution? If the Internet sector continues to retreat, the huge distribution would seem potentially ruinous, especially if the funds had been plowed back into the Internet sector and lost significant value. -- David Mullins
You can't assume that a fund with an enormous return will distribute an equally enormous capital gain at the end of the year. The size of fund's distribution really depends on how often and how astutely the manager trades securities within the fund.
Let's start by explaining how distributions work: In the language of taxation, a mutual fund is considered a "pass-through entity." That means all gains and losses from the sale of securities pass through to the fund's shareholders. (Dividends are also passed through.) If a fund's gains are larger than its losses, these realized gains, as they are known, must be distributed to shareholders each year.
But a fund might produce a sizable return over the course of a year and still distribute little or nothing to its shareholders.
For one, a manager may not trade very often; therefore, many of the gains in the fund would not be realized during the year. Say your fund manager bought
at the beginning of the year for 70 a share. The stock closed at 95 7/8 last Friday. That's a gain of 37%. But if the manager hasn't sold these shares, this gain was not realized and won't be distributed. At least not yet.
Even if the manager does sell this stock to capture a profit, such gains can always be offset by realized losses. And given what has happened with Internet stocks over the past few months, Internet fund managers have had plenty of opportunity to realize some losses to neutralize any gains in their portfolios.
Turnover, which measures the percentage of assets sold each year, is evidence of how much your fund manager is trading. If turnover is high, that could indicate a potentially large capital-gains distribution in the fund's future. But the turnover ratio for some Internet funds is not unusually high. It was 22% last year for the
Munder NetNet fund, for example. That means only about one-fifth of the fund's portfolio was sold.
The only way to know for sure the size of a fund's distribution is to hear it directly from the fund company.
So I called three of the best-known Internet funds to find out if indeed they are anticipating large capital-gains distributions for this year. The answer that I got from all three was a resounding no.
At the end of September, the Munder NetNet fund is expecting to make a capital-gains distribution of about 30 cents a share. That's less than 1% of the fund's current net asset value, or NAV. That's fairly low. Anything above 15% of NAV is considered high.
Internet fund is looking at a net realized loss of $30 million as of Aug. 31, says Lee Schultheis, chief operating officer of
Kinetics Asset Management
, which runs the fund. These losses can be carried forward and used to offset gains in future years. The fund won't make its actual distribution until the end of the year, but as it stands right now, the likelihood of a big distribution is nil.
The outlook for the
Monument Internet fund is about the same. David Kugler, president of the
Monument Funds Group
, says, "Right now, the net realized gain is zero. We're going to try to keep it close to zero." There are still a few months to go before the fund makes its actual distribution, but shareholders still "won't experience a significant taxable distribution," Kugler says.
If a realized gain is anticipated, a mutual fund manager typically won't set aside money during the year in preparation for a distribution down the road. Usually, a distribution to shareholders won't result in a significant cash outflow from the fund. "In the fund industry, almost all investors reinvest their distributions or dividends," says Bill Nygren, manager of the
Oakmark Select fund. Of course, shareholders will still owe taxes on the distribution, but in most cases, it never actually reaches their hands.
If you are concerned about a potential distribution from a fund, try to ascertain when it's coming and how big it will be.
Many mutual funds will make their distributions toward the end of the calendar year. But a fund can make a distribution at any time without advance warning.
It's also possible to get a distribution from a fund that had negative returns for the year. In that case, you may want to sell your shares in that fund to realize your own loss. And if you can sell them before the distribution is made, all the better.
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Dear Dagen aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.