Warburg Fund Investors Get Bad Tax News

Warburg Pincus Japan Small Company Fund, which rewarded investors with a 329% return last year, is about to present them with one of the biggest taxable gains in mutual fund history.

The fund on Monday distributed a short-term capital gain equal to about 55% of its net asset value per share, said Warburg Pincus Funds’ spokeswoman Leslie Mayock in New York.

Another fund, Warburg Pincus Japan Growth Fund, up 266% in 1999, paid out a short-term gain equal to about 22% of share value.

The irony: After soaring last year, both funds have plunged this year. They’ve each lost about 48% of their value since Jan. 1.

Gregg Wolper, an associate director of fund analysis at Chicago-based Morningstar Inc., said the big capital gains distributions illustrate the hazards investors can incur by chasing hot funds--especially those that are narrowly focused and prone to boom one year and bust the next.

“By chasing the performance in a super hot fund, you not only risk the danger of the fund’s fortunes turning south, but you can also get hit by taxes on gains that you didn’t even get,” Wolper said.

Excluding funds that realized big capital gains because they were liquidating, only four or five other funds in the past decade have had bigger distributions than Warburg’s Japan Small Company fund.

“It’s usually a very narrowly focused fund that has just a tremendously huge gain in one stock or sector, and then gets hit by redemptions the next year,” he said.

Linda Moore, Warburg Funds’ director of product management, said that many of the Japanese technology stocks that surged last year have plunged this year, hurting the funds’ returns.

The funds’ slide, in turn, has prompted many investors to pull money out. Japan Small Company’s assets have fallen to about $285 million from $1.1 billion at year-end, while Japan Growth’s assets are down to about $250 million from $836 million.

“[With] the high amount of redemptions, portfolio managers were forced to sell securities and take some of these short-term gains,” she said.

Most of the redemptions occurred earlier in the year, as some investors decided to lock in the huge returns the funds achieved in 1999, Moore said.

Thus, investors who bought into the funds as others were selling are taking the biggest hit: Their share price has tumbled, yet they still face a tax liability on the capital gains payout.

Japan Small Company has since raised its redemption fee, designed to deter short-term traders, to 2% of fund proceeds from 1% in May. Japan Growth, which didn’t have a redemption fee, has instituted a 2% fee.

But Wolper said a redemption fee is probably little deterrent to an investor who has made substantial gains, and wants to protect them by exiting. “A 1%, or even a 2% fee it seems . . . won’t have a whole lot of restraint on someone who is trying to protect say a 100% gain or a 300% gain,” he said.

Warburg Pincus decided to pay out the short-term gains now rather than wait until December, as funds usually do. “This way people will have the next three to four months to take a look at the rest of their portfolio, and figure out how they might try to offset some of this gain,” Moore said.

Fund investors will also face a long-term capital gains distribution in December, she said. Those gains will be disclosed in a supplement to the funds’ prospectuses. The funds may distribute some additional short-term gains as well, she said.