How Investors Can Avoid Effects of Capital Gains Distributions

Mutual fund investors who want to avoid, or at least minimize, the effects of capital gains distributions have several options.

* Own index funds, which tend to generate fewer realized capital gains because of their passive management (i.e., they try to buy and hold shares). Index funds are designed to replicate the performance of a benchmark such as the blue-chip Standard & Poor’s 500-stock index.

* Choose “tax-managed” funds. These funds are designed to minimize the annual tax bite through various accounting and trading strategies. Vanguard Group’s five tax-managed funds, for instance, have distributed no gains since their inceptions (in 1994 for three funds, 1999 for the other two).

But a fund’s attempt at tax-management is no guarantee: The Standish Small-Cap Tax-Sensitive Equity Fund made two gains payouts in 2000 because a manager change spurred a portfolio make-over, according to Morningstar Inc.

It may be worth checking your fund’s prospectus to see whether the portfolio is run with an eye toward tax management, even if the fund name does not include Tax-Managed, Tax-Sensitive, Tax-Aware or similar language.

* Check a fund’s “embedded” gains or losses before buying. Fund company phone representatives usually can tell you whether a fund has positive “capital-gains exposure,” meaning a net paper gain in its holdings that could be realized in the future.

Morningstar’s Web site (https://www .morningstar.com) also includes this information. From any fund’s Snapshot page on the site, click on Tax Analysis.

* Look for funds with a history of low portfolio turnover. That is no guarantee that a fund won’t generate capital gains distributions in the future, but a buy-and-hold investing style is a good start.

In particular, low turnover can minimize a fund’s realized short-term gains, which are taxed at a higher rate than long-term gains.

* Check a fund’s history of gains distributions. Again, it’s no guarantee, but if a fund has paid out few large gains under a particular manager, he or she might continue to be effective at minimizing the annual tax bite.

Fund companies provide distribution histories for recent years. Also, Morningstar’s tax analysis on its Web site provides a fund’s “after-tax returns” for the trailing three-, five-and 10-year periods (excluding any capital-gains effects that would result from selling the fund at the end of the period).