Fund Losses Can Shelter Gains in the Future

There’s one upside to the devastating losses many stock mutual funds have incurred since 2000: A big chunk of any future gains may be sheltered from taxes.

“Fund investors are at a rare advantage now because the portfolios have all these losses on their books that can offset future gains,” said Steve Cohen, chief financial officer at money manager RS Investments in San Francisco. “It’s not the reason you should buy a fund, but it’s an added bonus, a silver lining.”

Mutual fund companies can’t pass their realized portfolio losses directly through to investors. But if the funds revive, shareholders may benefit indirectly as accumulated losses offset newly realized gains, thus diminishing the likelihood of capital gains distributions. Funds can carry losses forward for eight years.

Federal law requires mutual funds to distribute any net realized capital gains (that is, gains in excess of losses) to shareholders each year. It’s a ritual many fund investors abhor--especially in years when funds’ overall portfolio values have declined.

In 2000, many downtrodden funds paid capital gains distributions in part because appreciated stocks had to be sold to pay off fleeing investors. That left remaining shareholders with the double whammy of a tax hit and a drop in their fund’s value.

But this year, if the stock market continues to rally, many fund owners may find the situation reversed: Their fund share price will rise, yet they won’t face capital gains distributions.

Of course, investors who own funds in tax-sheltered accounts, such as 401(k) plans, don’t worry about capital gains payments anyway.

For investors looking to put money to work in taxable accounts, however, accumulated tax losses can be a significant issue.

Here are some of the funds that might be able to benefit in 2002 and beyond from losses on their books:

* At RS Investments, a notice on the home page (www.rsfunds.com) alerts investors to losses in several portfolios. RS Contrarian fund, for example, had a loss as of Dec. 31 of about $18.78 per share, or 186% of the fund’s net asset value; RS Emerging Growth had a loss of $18.23 a share, or 57% of NAV; and RS Diversified Growth, $4.48, or 19% of NAV.

“If you have been thinking about investing in an RS fund or are a current shareholder and would like to add to your investment,” the notice says, putting a positive spin on a rough market, “this is an excellent time to take advantage of the current tax-loss carry-forward situation in some of the funds.”

* At Valley Forge, Pa.-based Vanguard Group, several funds have booked losses, including Vanguard U.S. Growth, with an estimated loss of more than 40% of the fund’s NAV, even though performance has picked up since a manager change in late June; Vanguard Morgan Growth, with a loss worth about 20% of NAV; and Vanguard Tax-Managed Capital Appreciation, with a loss of about 12% of NAV.

“There are no guarantees, of course, when it comes to distributions, but for someone buying in right now, these cushions are likely to help insulate them from a tax event for a while,” said Joel Dickson, a Vanguard principal who specializes in tax issues.

* At T. Rowe Price Group Inc. in Baltimore, several funds have booked losses estimated at more than 10% of NAV, including: T. Rowe Price Media & Telecommunications, T. Rowe Price Tax-Efficient Growth and T. Rowe Price Tax-Efficient Multi-Cap Growth. Funds with smaller losses include T. Rowe Price Growth Stock and T. Rowe Price Mid-Cap Growth.

Because they absorbed the brunt of the bear market’s damage, growth stock funds generally are sitting on the heaviest losses.

“Most growth funds have a comfortable tax position, and they’ve also had two years of dramatic underperformance,” said Russ Kinnel, director of fund analysis at Morningstar Inc. “Altogether, that makes this an attractive time to consider buying a growth fund, especially if you’re under-represented in that area.”

Growth-oriented Van Wagoner Funds in San Francisco and Janus Funds in Denver are among the other firms with substantial realized losses in some of their portfolios.

At Invesco Funds in Denver, manager Tim Miller, whose Invesco Dynamics fund has a loss carry-forward worth about 20% of NAV, said that gives him “a lot to work with” in terms of tax-efficient trading strategies.

“I don’t want to make light of negative returns,” Miller said, “but for the investor looking at a fund from a fresh perspective, our sales pitch would be that we’ve stayed true to our growth discipline, which has hurt us [relative to our peers], but from the recent performance you can see that we’ve fully participated in the market’s recovery, and we’re optimistic about the future.”

Though Miller’s fund lagged behind its mid-cap growth category average in 2000 and 2001, its longer-term record is better than most, and it has surged 30% in the last three months.

For investors who own funds in taxable accounts, booked portfolio losses are only one tax-related factor to consider, experts note. The fund manager’s history of tax efficiency is at least as important, they say. Tax efficiency refers to a manager’s efforts to minimize annual capital gains distributions either by sticking to a buy-and-hold philosophy or by deft trading, or both.

Kurt Brouwer, an investment advisor in Tiburon, Calif., said he would give a fund such as White Oak Growth Stock extra credit because manager James Oelschlager’s history of low turnover and shrewd trading has generated few capital gains distributions over the years. The fund now has a loss carry-forward worth roughly 22% of NAV, said Akron, Ohio-based Oak Associates.

Charles Rinaldi, who took over as manager of the Strong Multi-Cap Value fund in mid-May, notes that he inherited realized losses from the previous manager and that he has a strong record of tax efficiency as manager of Strong Advisor Small Cap Value.

“No promises, but in my opinion there probably won’t be any capital gains distribution in the Multi-Cap fund over the next two years,” Rinaldi said. “I’m a shareholder in both funds, and I certainly don’t want to have to pay any taxes myself.”

Vanguard’s Dickson suggests that investors read a fund’s prospectus and recent shareholder communications to get a sense of whether the manager is concerned about tax issues.

“If there’s no mention of taxes in the day-to-day management of the fund, assume any historical tax efficiency is an accident,” he said.

There are other caveats to consider before betting on a fund in part for its accumulated tax losses. If a fund’s assets swell because the market continues to rally or because investors pile in with new cash, the per-share value of losses on the books could get watered down, Dickson said.

Remember too that the first order of business is to find a fund that meets a specific need in your portfolio, financial advisors say.

The other basic consideration is that an investor must be confident that a beaten-down fund is in fact poised to rebound. Until a fund is generating new gains, any accumulated tax losses can’t do shareholders much good.

Said Invesco’s Miller: “You never want to make a bad investment decision for tax purposes.”