A Worth-Case Scenario for Index Funds

Is there a nasty surprise buried in the stock index funds that have become wildly popular these days? Possibly.

The great selling point of these funds is that they keep costs very low, trade infrequently and pull in most of the stock market’s gain by buying most of the stock market.

The Vanguard Index Trust 500, for example, holds all of the stocks in the Standard & Poor’s 500, in proportions based on each company’s market capitalization. It sells only when it has to because investors are asking for their money back. And it buys only when more money comes in.

This delivers big advantages to investors who hate paying capital gains taxes on their mutual fund distributions every year. Index funds trade infrequently, realize few capital gains and grow as irrationally and exuberantly as the market itself.

So . . . what happens if the market goes the other way?

Here’s a worst-case scenario: Investors bail out.

Index fund managers, forced to sell their portfolios in prescribed proportions, incur huge capital gains when they sell S&P; 500 stocks they may have been holding for years.

At year’s end, investors who came on board in the last year or two could end up with less money than when they started the year and have a big tax bill on phantom profits that other investors, earlier to the table than they were, reaped.

That’s a not-so-pretty picture painted by Peter Forbes, a Washington, D.C., investment advisor who happens to like the concept of index funds in general. It’s just that lately he’s getting a little nervous about them.

Indexes have shifted from being staid, steady slow-growers to becoming a “momentum buy.”

People are now buying S&P; 500 index funds because everybody else is buying them. Such mob-rule investments increase risks on the way down. In a sell-off, Forbes points out, index funds tend to have the highest unrealized capital gains.

Morningstar Investments points out, for example, that the Vanguard Index 500 currently has a 24% capital gains exposure. That means if the portfolio manager sold stocks today, almost one of every $4 received would come as a gain taxable to shareholders at year-end.

How big a worry is this? Maybe not as big as worst-case scenarios indicate.

For one thing, the Internal Revenue Service will allow you to adjust your cost basis when you sell the index fund. In other words, you can see this kind of tax hit as prepaying the capital gains that you expect to reap eventually anyway. It’s not wise to pay taxes early, of course, but at least you’ll have a smaller gain (or bigger loss) for tax purposes later.

Also, Russel Kinnel, head of stock fund research at Morningstar, offers the dubious comfort that in a down market falling prices could erase some of those gains, and he reports no evidence that index fund investors would flee faster--or even as fast--as the typical stock fund shareholder.

But Kinnel also reports that it is relatively easy to protect yourself from the index-fund tax trap. If you are holding the funds in a taxable account, buy an index that is managed for tax efficiency. Vanguard has several that are so managed, and the Schwab 1,000 broader stock market index fund is too.

How does an index fund become tax efficient? The managers of these funds are allowed to sell stocks to minimize taxes. So in a sell-off, instead of having to sell a little piece of every stock, these managers can sell losers to offset gainers, or just sell losers.

That takes a careful manager. Too many loser-only trades, and the fund is no longer representative of its index. At the worst extreme, a fund that sells only losers could institutionalize buying high and selling low. And we don’t need fund managers for that; many of us are quite good at doing it ourselves.

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Linda Stern is a free-lance writer who covers personal finance issues for Reuters. You may e-mail her at 72160.1546@compuserve.com or write to her in care of Reuters, Suite 410, 1333 H St. N.W., Washington, DC 20005.