If you're concerned that the new

Republican

administration will mean the end of investor-friendly securities regulation, you should take heart from the

Securities and Exchange Commission's

recent

adoption of a rule requiring that funds disclose their after-tax returns.

The rule was approved under a commission controlled by Democrats, but owes its existence to a Republican, Rep. Paul Gillmor of Ohio.

In 1999, Gillmor proposed a bill to force the SEC to require mutual funds to disclose their after-tax performance. The bill was passed overwhelmingly by the Republican-controlled

House of Representatives

.

Before the

Senate

could act, and to avoid being upstaged by

Congress

, the SEC adopted a rule on its own. But while the SEC's rule will help investors better appreciate the effect of taxes on mutual fund returns, it falls short of the purpose of Gillmor's bill in important ways.

Even so, the fund industry is pushing the SEC to roll back the rule, an effort the commission has, thus far, resisted.

Under the new rule, most mutual funds will report in their prospectuses after-tax returns for one-, five- and 10-year periods under two formulas. The "pre-liquidation" formula assumes a shareholder remains invested in the fund and pays taxes only on distributions made during the year. The "post-liquidation" formula assumes the shareholder redeems his shares and pays taxes on distributions and on capital gains from the sale. After-tax returns assume a 39.6% tax rate, the highest current rate.

Why Taxes Matter

After-tax performance has a big bottom-line impact for many of the 88 million Americans who invest in mutual funds. Unlike shares of stock, on which you pay capital gains tax only when you sell, mutual fund shares subject their owners to capital gains taxes even when they don't sell. That's because mutual funds are required to distribute annually almost all of their income and gains.

Mutual funds make tens of billions of dollars in taxable distributions each year, cutting their total returns by about 15%, on average. Taxes often have an even greater impact than fund fees. "Recent estimates suggest that more than two and one-half percentage points of the average stock fund's total return is lost each year to taxes," notes SEC Chairman Arthur Levitt, "about one percentage point greater than the amount lost to fees."

The effect of fund distributions can be painful. For example, shareholders can be hit with a substantial tax bill on an investment that has lost money.

If you started last year with $10,000 invested in the

(WPJPX)

Warburg Pincus Japan Small Company fund and reinvested all distributions, your account was worth only $2,420 at year-end, a drop of 71.8%. Adding insult to injury, you would owe taxes on $4,070 in income and capital gains distributions.

Although large distributions can result from forces beyond fund managers' control, as often as not they could have taken steps to control the amount of annual distributions. They can sell stocks that have declined in value to offset gainers, or they can simply turn over their portfolios less.

Warren Buffet

has often opined that the ideal holding period for a stock is "forever." Yet the average fund sells 90% of its portfolio each year.

The Information You Really Need

While the new rule satisfies the literal requirements of the Gillmor bill, it falls far short of providing investors with all of the information they need to make informed investment decisions.

First, it does not require that funds provide investors with the information that would best protect them against tax surprises: the amount of realized gains and income awaiting distribution. The SEC should require that this information be made available to investors on funds' Web sites or by mail upon request, so that investors will not be blindsided by surprise distributions.

An investor who put $10,000 into Warburg Pincus Japan Small Company on Aug. 11 last year would have received an unexpected -- and assuredly unwelcome -- taxable distribution of $5,500 a few days later. This is known as "buying a dividend."

One participant in a

Morningstar

bulletin board asked whether "a distribution of this magnitude constitutes a material fact which needed to be disclosed in advance to avoid defrauding investors." Under current law, the answer is unclear. If the SEC required this disclosure, however, the answer would, as it should, be yes.

Misleading Ads

Another problem with after-tax performance is that the SEC's release adopting the new rule implies that funds can omit after-tax returns from their ads even if doing so is inherently misleading.The

(EASGX)

Eastcliff Growth fund, for example, can advertise its before-tax, three-year return of 11.37% without mentioning that the fund's after-tax return was negative 0.35%, according to

Morningstar

.

Common sense dictates that Eastcliff should have to include after-tax returns in its ads if it includes any performance information at all.

Congressman Gillmor agrees. "If you let funds disclose only pre-tax information and not after-tax returns, it is clearly a glaring omission for somebody who wants to determine how a fund has performed in the past,'" says Gillmor. "If a fund shows performance in an advertisement,

it should show . . . the real return."

Beware the Ides of March

Rather than looking to improve the rule, however, Gillmor should be more concerned about the current version's surviving the next few months. The

Investment Company Institute

, the fund industry's lobbying arm, asked the SEC last week to subject the rule to

President Bush's

Regulatory Review Plan. The plan imposes a moratorium on new rulemaking by executive agencies pending review by Bush appointees.

This might seem reasonable, except that the SEC, as an independent agency, is not subject to the plan. Furthermore, the after-tax rule became effective two days

before

the plan was established and Bush became president.

The three amendments to the rule requested by the ICI would cripple the effectiveness of the new disclosure.

The ICI wants to bury after-tax returns near the back of the prospectus, rather than include it with pre-tax returns for ease of comparison. It also argues against using the 39.6% federal income tax rate, despite the fact that it has become the standard for most funds when presenting after-tax returns. And even though it's the top federal rate, it can still understate the tax burden because it does not reflect state and local taxes

Finally, the ICI contends that after-tax one-year returns should not reflect short-term capital gains on the theory that most shareholders hold their shares for more than a year to get long-term tax treatment. In fact, many shareholders hold their shares for less than one year. Applying the short-term rate to one-year returns is necessary to highlight the bigger tax hit that selling shares in less than one year can impose. In an interview with

Ignites.com

, an online newsletter, Paul Roye, who heads the SEC's funds division, said of the ICI's proposal, "they want us to adopt a fiction for purposes of the calculation."

The ICI presented each of these arguments before the rule was adopted. The SEC wisely rejected all of them, and apparently hasn't changed its mind. "I hope the ICI is not trying to hide the information," Roye told

Ignites.com

.

If it can't sway the SEC, perhaps an opportunistic fund industry believes that a Bush presidency means an undiscriminating rollback of investor-friendly regulation by Congress.

But Congressman Gillmor has a different view. Bailey Wood, Gillmor's press secretary, told me that "Congressman Gillmor is happy with the rule, and he wishes it to remain exactly as is."

Who Needs the SEC?

What's driving this Ohio congressman to defy his Republican label and look to government regulation to benefit mutual fund shareholders? On the one hand, Republicans may recognize that with Congress nearly split down the middle, winning investors' votes may hold the key to the 2002 elections, as I pointed out in a

previous column.

Gillmor's fellow Republicans aren't waiting for the new disclosure to get voters' attention. Rep. Jim Saxton, R-N.J., introduced a bill last summer that would allow fund shareholders to defer up to $3,000 a year ($6,000 for couples) in capital gains distributions that are automatically reinvested in fund shares.

Congress should go one step further and allow deferral of 100% of reinvested capital gains. Not only would this encourage long-term investing, it also would level the playing field for fund shareholders and investors in stocks, who pay capital gains taxes only when they sell their shares. This would reduce risk by making mutual funds, which are typically more diversified than investors' stock portfolios, more attractive investment options.

On the other hand, it may be the possibility of killing two birds with one stone that prompted Gillmor to propose his bill. I asked him whether his real motive in pushing for after-tax disclosure was to highlight the effect of taxes and to promote future tax cuts. "No," responded Gillmor last fall, "but if it had that beneficial collateral effect, that would be fine with me."