While few mutual funds delivered positive returns last year, some of the biggest losers ultimately could deliver the largest tax benefit to investors, as accumulated net capital losses may offset future gains.
While few mutual funds delivered positive returns last year, some of the biggest losers ultimately could deliver the largest tax benefit to investors, as accumulated net capital losses may offset future gains.
Funds generate capital gains distributions when they sell a security that has appreciated, and shareholders have to pay taxes on that gain. But if a fund has a net capital loss embedded in the portfolio, that loss can be carried forward and used to offset future capital gains distributions, sparing investors a tax bill.
"I think we are starting that tax holiday now," said Tom Roseen, a Denver-based senior research analyst with Lipper Inc. of New York.
NET CAPITAL LOSSES
"Any losses from the past year will be carried forward," said Christopher Davis, a fund analyst at Chicago-based Morningstar Inc., adding that funds may carry losses forward for up to seven years.
According to Morningstar, of the 5,793 individual portfolios with potential capital gains exposure last year, an estimated 5,490 funds posted a negative or accumulated net capital loss by Dec. 31.
The total number of funds more than doubled from the previous year, when 2,023 funds had an embedded loss. In addition, the number of funds with an embedded loss of 100% or higher grew to 679 last year, from 173 in 2007.
"Shareholders are getting the functional equivalent of a tax-deferred fund without having to hold it in a tax-deferred account," Mr. Davis said.
And researchers say it will take years for the losses to work out of the funds.
"I think we'll have a good, long period of a tax holiday — at least four years," Mr. Roseen said.
As a result, investors may find that a fund that was mauled is worth holding on to.
"We now have become 'stuck-holders,'" said Geoff Bobroff, an East Greenwich, R.I.-based mutual fund consultant. "It could probably be in our best interest to stay with a fund rather than liquidate it and lose the loss carry-forward that might otherwise be there."
Investors should consider the embedded loss if they are looking to switch to a new manager, Mr. Bobroff said.
"The investor should look at the manager's ability to do well in an up market," he said. "If they don't have that ability, it may be a good idea to switch horses and buy into a fund with losses that carry over, because you'll benefit from that."
Financial advisers said that the tax issue isn't the top criterion for choosing a fund, but it can be a deciding factor.
"If it's buying a fund with money sitting on the sidelines, the tax loss should definitely be a factor," said Chuck Gibson, president of Financial Perspectives of Newark, Calif., which has $50 million in assets under management.
NOT A DRIVING FORCE
But he said he wouldn't sell a fund in a portfolio to buy another just because of the tax issue. Taxes shouldn't be the driving force, Mr. Gibson said.
"If you are comparing funds, and all else being equal, then absolutely, you should buy the fund with the most embedded loss," he said. "The capital loss can also make a difference in deciding whether to hold on to a fund."
Other advisers agree that the tax factor can make a difference.
"In a competitive situation, when you have 10 funds and you need to pick three for the buy list, then we'll delve into that [tax implication]," said Michael Kalscheur, a senior financial consultant with Castle Wealth Advisors LLC of Indianapolis, which has $100 million in assets under advisement. "If you have a manager with an embedded capital gain, versus one with an embedded loss, I'd much rather gamble on the one with the embedded loss."
Taxes are part of the decision of which account to use, said Carolyn McClanahan, president of Life Planning Partners Inc. of Jacksonville, Fla., which has $25 million in assets under management.
"When a fund is sitting on a large amount of capital losses, I am more apt to use it in a taxable account. It will be awhile before it pays capital gains," Ms. McClanahan said.
"I also look at the turnover ratio of the fund, because that increases the likelihood of taxes too," she said.
The issue is also a consideration at the end of the year.
"When money is being invested at the end of the year in a taxable account, I don't want to invest into a fund which will result in a capital gain," Ms. McClanahan said.
Taxes play an important but small role, said Barry Glassman, a senior vice president of Cassaday & Co. Inc. of McLean, Va., which has $1 billion in assets under management.
Investors should research the manager, philosophy and performance of a fund first, he said.
"An added component of a fund's due diligence needs to be embedded-loss research," Mr. Glassman said. "There are some funds that have an enormous carry-forward loss, and it may make sense to purchase that fund to potentially put off capital gains for a longer period of time. But taxes should not lead the investment decision of whether or not you buy it or stay in a fund."
Still, investors need to do their homework, Mr. Davis said.
"You have to ask yourself: Why did that fund have such a sharp decline in potential capital-gains exposure? You have to try to figure out what are the fund's future prospects," Mr. Davis said.
"Sometimes it's a sign of failure," he said. "The ideal situation is to find a good manager who was caught in a bad environment."
After the last bear market, many funds had losses that offset capital- gains distributions for several years. Total capital-gains distributions dropped to $40.6 billion in 2001, from $298 billion in 2000, according to Lipper.
E-mail Sue Asci at sasci@investmentnews.com.
