The trouble with mutual funds

The pain continues this winter as equity funds start distributing taxable capital gains payments. Ouch.

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Risky business: CNN senior correspondent Allan Chernoff.
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NEW YORK (CNNMoney.com) -- As you cringe over your mutual fund statements, you may be thinking, "This can't possibly get any worse!" Think again.

Even if the stock market treads water through the end of the year, mutual funds can still inflict financial pain. That's because your funds likely have an end-of-the-year gift waiting for you: a taxable capital gains distribution.

It's bad enough that fund returns have been awful this year, most worse than even the S&P 500's abysmal 33% loss, according to Morningstar. Now we have to brace for a second whammy.

"There's a shock factor," warned Thomas Henske, financial advisor with Lenox Advisors. "A lot of people won't believe their account values went down and there's a tax on it!"

Even though 99.97% of U.S. equity mutual funds are down on the year, as calculated by Morningstar, the IRS still requires managers to make end-of-year capital gains distributions, on which shareholders must then pay taxes. It doesn't hurt so much when the fund has done well by you, but it's painful when investors have already suffered such losses.

There has been so much money pulled out of equity mutual funds -- $46 billion in September and $111 billion year-to-date, according to AMG Data Services -- that to meet those redemptions, fund managers have been forced to sell holdings, in some cases stocks they may have owned for years that still had capital gains when they were unloaded.

What to do? If the mutual fund is in the red, sell out of it, or at least sell the bulk before the distribution comes. That helps you to avoid the taxable distribution and allows you to take a tax loss on your fund holding, which can offset capital gains and even ordinary income up to $3,000.

"When you have lemons make lemonade," said Henske. "One of the smartest things people could do is going through their portfolios and realize losses now."

Don't bail out of the stock market. In this volatile environment, bailing out could mean you miss a big rally. Instead, if you sell a fund holding, replace it with an Exchange Traded Fund (ETF).

If you're selling a domestic, large capitalization equity fund, replace it with the S&P 500 SPDR Trust (SPY) Exchange Traded Fund, for example. If you're selling a broad-based international equity fund, you may replace it with the iShares MSCI EAFE Index Fund (EFA), the largest international exchange traded fund. For sector mutual funds there is a wide variety of sector ETFs.

You can move back into the fund (assuming it's not closed to new investors) early next year. But, in your taxable accounts, some financial advisors prefer sticking with ETFs and individual stocks.

"The tax inefficiency is always an issue," said John Olson, a wealth management advisor and senior vice president with Merrill Lynch. "We try to use them in tax sheltered retirement accounts and not have too many in taxable accounts."

In mutual funds you don't have control over taxes. For example, you may be buying into a portfolio that has owned Microsoft since back in the early-to-mid 1980s. "If the portfolio manager decides to trim the position or sell entirely, you get hit with your share of the gain, even if you bought in last month," said Olson.

Another issue to keep in mind is that many managers have done a poor job of protecting shareholders, partly because their fund restricts their investment strategy.

A large-capitalization value stock fund will often have a mandate to invest in just those stocks, not to rush into Treasurys when the stock market begins to sell off. Many fund managers must remain nearly fully invested, be it a bear or bull market, shifting only their stock holdings.

"Mutual funds are not nimble," cautions Kathy Boyle, president of Chapin Hill Advisors. "A fund manager has a mandate and you have to read the prospectus to know, does he have to stay fully invested?"

Still, some experts say, investors should not give up on mutual funds, which do offer an easy way for individual investors to participate in the stock market's potential for a rebound.

"Perhaps it's time to trade up to a better manager," suggests Karen Dolan, director of fund analysis at Morningstar, who believes in sticking with good mutual fund managers for the long term. "They're professionally managed. You're hiring a team, a manager and team who do it for a living, who do the worrying for you," said Dolan.

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