A Double Whammy by Funds
For the second year in a row, many stock mutual fund investors are facing a double dose of bad news.
Despite the market rally of the last two months, the average domestic equity fund is down more than 13% year to date. Now, many funds are embarking on an annual ritual that can be painful to investors no matter what their fund’s performance: capital gains distributions.
If your fund is underwater this year, but you’re still getting a capital gains distribution in a taxable account, welcome to the world of the double whammy.
“Because a lot of funds have done so poorly, investors are going to have that nasty feeling again,” said Don Cassidy, senior research analyst at fund tracker Lipper Inc. in Denver. “It just won’t be nearly as painful as last year.”
Indeed, the good news is that gains distributions will be less common and generally smaller than they were in 2000 because of the bear market.
Still, many funds will be unable to avoid making capital gains distributions, the bulk of which will be paid out in December, as usual. Such distributions are taxable to investors unless a fund is held in a tax-favored account such as a 401(k) or IRA.
Some funds already have made payments this year. Through October, 416 stock funds made distributions, according to fund tracker Morningstar Inc. That total was down from 644 funds in the same period a year ago.
By law, mutual funds each year must distribute to shareholders their net profits from the sale of securities. Even in a year when a fund’s share price has fallen because the stocks in the portfolio have declined in value, the fund still may have racked up net capital gains as the manager sold stocks along the way.
For shareholders, these capital gains payouts are taxed at short-or long-term rates based on how long the securities were held in the fund--regardless of how long the investor has held the fund’s shares. Funds instruct investors how to report the payouts on their tax return.
In one sense, capital gains distributions are a wash for a buy-and-hold investor of a fund: As a distribution is made, a fund’s share price is adjusted downward to reflect the payout. Most fund owners reinvest their capital gains, so they receive more shares at the adjusted lower price. When the investor eventually sells the fund, there may be little or no taxes due, because they’ve been paid with each distribution.
Even so, many investors naturally dislike owing taxes each year on fund payments, especially in periods when fund values are declining or up only slightly.
But that was more of a problem last year than it will be this year, Cassidy said. He said the abnormally high distributions of 2000 were exacerbated by the stock market’s stunning reversal: a first-quarter surge followed by a prolonged slump. Some funds had to realize capital gains to meet redemptions by fleeing investors, and those gains were magnified on a per-share basis when distributed to a dwindling shareholder base.
Among the more serious double-whammy situations last year: Standish Small-Cap Equity fund, which lost 19.3% in 2000, made a distribution equal to 89% of its per-share net asset value (NAV), according to Morningstar. Nicholas-Applegate Global Technology fund, which sank 36%, paid out the equivalent of 46% of its NAV.
Although distributions are expected to be less common and lighter overall this year, Cassidy said investors in certain types of funds should be on the lookout for payouts. These categories comprise the few strong performers, including “short” funds, which bet against individual stocks or the general market; “balanced” funds, whose bond stakes may have fared well; and real-estate and precious-metals funds, two sectors that are in the black for the year.
Overall, Morningstar estimates that most funds will distribute a little less than 1% of their NAV this year, on average, whereas last year’s distributions were typically 10% to 15% of NAV.
Still, anyone thinking of investing in a stock fund before year’s end may want to call the company before cutting a check. If you buy just before a fund makes a gains distribution, you’ll owe taxes on the payment. In a sense, you’re getting other shareholders’ tax bill. Many financial advisors suggest waiting to buy until a fund is “ex-dividend,” meaning after the distribution is made and the per-share NAV price has fallen.
Vanguard Group, Fidelity Investments and most other fund companies have begun posting estimated capital gains distribution schedules on their Web sites to help investors with their tax planning. Shareholders without Internet access can call a fund’s toll-free number to get the information.
Vanguard spokesman Brian Mattes said that 45% of the firm’s stock funds made distributions last year. This year, by contrast, 30% of the funds are expected to distribute gains.
Fidelity and Janus Capital Corp. also expect lighter distributions this year. Fidelity estimates that none of its funds will be making distributions exceeding 6% of NAV. At Janus, just seven of 18 stock funds are expected to make distributions, all less than 1% of NAV, the company said.
While few whopping payouts are forecast, some fund firms are estimating significant distributions for certain portfolios.
AIM Global Health Care Fund, for example, is expected to pay out $4.09 a share, or about 13% of the current NAV, to shareholders of record Dec. 13. Yet the fund’s total return year to date is just 2.8%, so shareholders might be surprised by the size of the payout.
RS Value + Growth fund is expected to pay out $2.69 a share, or 14% of NAV, to shareholders of record Dec. 5--even though the fund’s return so far this year is a negative 21%.
Dreyfus Small Company Value Fund, up 15.5% this year, is expected to pay out $6.40 a share, or 25% of NAV; T. Rowe Price Financial Services, down 4.4% year to date, is expected to pay out $1.71 a share, or 8% of NAV.
Investors should note that all estimates are just that; actual payouts may vary, fund firms warn.
Although distributions can be annoying, financial planners advise fund owners not to let the tax tail wag the investment dog. If a fund is meeting your investment objectives it’s probably worth keeping even if you incur a tax hit.
