Mutual funds are supposed to be a bit dull; when they get
interesting, watch out. On Nov. 11 of last year, a 67-year-old
physician in San Francisco invested $50,000 in a mutual fund
called BT Investment Pacific Basin Equity. (Since he has asked
me to keep his name confidential, let's call him Dr. X.) Then,
early this January--scarcely seven weeks after he had bought the
BT fund--Dr. X opened an innocent-looking envelope and got the
shock of his investing life. On his original $50,000 investment
($50,363.48, to be exact), BT Pacific Basin had paid out
$22,211.84 in taxable capital gains. This was not good: Every
penny of the payout was a short-term gain, taxable at Dr. X's
ordinary income tax rate of 39.6%. On a fund from which he had
not sold a single share, he suddenly owed nearly $9,000 in
federal taxes. As a California resident, he was also in the hole
for $1,000 in state tax.
How is Dr. X feeling? "Ripped off," he says. "This is truly
outrageous. I'd thought if a fund were properly managed this
kind of thing wouldn't occur--or, at the very least, I should
get enough forewarning to get out of the fund before it did
occur." And what has he learned? "Oh, I should have been much
less accepting of the idea that fund managers will do the right
thing for their investors," he says with a bitter laugh.
"Evidently they don't."
Al Coles, the financial planner who put Dr. X in the fund,
believes BT should have notified potential investors of the
pending tax liability. "Fund companies love sending investors
all this marketing crap that doesn't mean anything," says Coles
of Financial Design Associates in Stinson Beach, Calif. "So how
come when there's a vital and valuable piece of information,
they can't be bothered to send it out?"
Capital-gains taxes without the gains
Could you end up in the same mess as Dr. X? You bet. Stock and
bond funds paid out $184 billion in taxable gains in 1997 and
another $166 billion in 1998. Those payouts cost investors
roughly $50 billion in federal taxes each of those years. And in
the zany world of fund taxes, you don't owe Uncle Sam only when
you sell at a profit. You can owe when your fund sells one of
its holdings at a profit, even if you've never sold a share. As
with a stock split, when a fund makes a distribution, the total
value of your account does not change, but you end up owning
more shares at a lower price. Unlike a stock split, however, a
fund distribution is taxable immediately--regardless of whether
you reinvest it in more fund shares or the fund company sends
you a check.
A poorly managed fund can even stick its investors with a big
capital-gains bill at a time when the fund is losing value. This
happens if the fund sells its winners without offsetting those
gains by selling some losers, and it happens far more often than
investors realize. All told, investment analyst James Garland at
the Jeffrey Co. in Columbus, Ohio estimates that federal taxes
consumed a hair-raising 47% of the typical stock fund's
performance from 1971 to 1995. On the other hand, several
well-managed funds, including Vanguard Tax-Managed Capital
Appreciation and Schwab 1000, have never paid out a taxable
capital gain and have allowed their investors to retain at least
97% of their performance after taxes. In short, whether your
fund manager beats the market is entirely out of your hands (and
perhaps his too), but it's well within your power to choose
funds that will not torture you at tax time.
To make the best choices, it helps to understand how mutual
funds handle taxes. Let's say you're in the 31% federal tax
bracket and you own two funds, both of which go up 10% for the
year. One fund generates only unrealized paper profits, leaving
you with $1,100 for each $1,000 you invested. At the other fund,
however, winners are sold within 12 months and the gains are not
offset by selling losers. As a result, all the profit is
realized as short-term capital gains; this account too is worth
$1,100--but you've got to pay Uncle Sam $31, or 3.1% of what you
invested. That reduces your 10% pretax gain to just 6.9%. After
tax, the first fund is a better deal.
"Perhaps we were too successful"
When Dr. X bought BT Pacific Basin, what he got instead of a
mutual fund was a tax grenade whose pin had already been pulled.
The fund had generated the bulk of its capital gains months
earlier. By early November, the time to offset them with losses
was running out fast. Only on Nov. 19 did BT finally estimate
that it would distribute more than $2 a share in short-term
gains--but, unlike many other fund companies, BT did not share
that warning with discount brokers, transfer agents and other
third parties. You had to call and ask.
I asked BT to explain. Warren Howe, co-manager of the Pacific
Basin fund, says the taxable gains were generated by BT's
successful trading of Asian currencies--which helped push the
fund's performance far ahead of its peers in 1998. (The fund,
which buys stocks in the Far East outside of Japan, finished
1998 with a return of -6.6%.) "We did make a lot of money on
currencies," said Howe. "Perhaps in some sense we were too
successful." Perhaps. But panicked by the plunge in emerging
markets, investors pulled their money out of the fund throughout
1998. The currency gains were achieved early in the year, when
the fund had about $30 million in assets; by December, when the
assets had fallen to $4.2 million, far fewer shareholders
remained, and they got stuck with all the taxable gains.
Wouldn't it have been a good idea, I asked Howe, for your
prospectus to warn investors that aggressive currency trading can
have unpleasant tax consequences? His answer came in a bland tone
of detachment: "I haven't really got a strong view on whether it
should be specifically disclosed. I'd think that would be
something that the investor base should already be aware of."
And should BT have tried harder to spread word of the pending
payout? Howe rightly pointed out that it's not portfolio
managers, but other fund company executives, who make that kind
of decision. But, he conceded, "I suppose that would have been
fair under these circumstances."
And what words of encouragement would Howe offer Dr. X, after the
doctor had been forced to pay a $10,000 tax bill on his $50,000
"Our currency management made a positive contribution to return,"
said Howe, "even after tax."
Howe's response is a reminder that many fund bigwigs share the
haughty view of Leona Helmsley: "It's the little people who pay
taxes." Luckily, we little people can protect ourselves from fund
tax bombs. Here's how:
Listen to history. Last year was the second in a row that BT
Pacific Basin dumped a big tax bill on its shareholders. Funds
with high taxable payouts in the past will tend to have them in
Watch the calendar. Around Thanksgiving, many funds give
warning of their year-end taxable payouts. If you haven't
invested earlier in the year, hold your fire until a tax
estimate is available. If the pending payout turns out to be
big, find a different fund.
Read the fine print. Every fund's annual and semiannual
reports (available from the company or online as "Form N-30D" at
www.freeedgar.com) include a statement of assets and
liabilities. Look for this lingo: net unrealized appreciation,
undistributed net investment income and undistributed net
realized gain. While they can change by the end of the year,
these numbers are fair estimates of tax overhang; if together
they exceed, say, 15% of total net assets, you're looking at a
fund that could make you a tax victim. Last Nov. 23, after Dr. X
had already invested, BT Pacific Basin filed its Sept. 30 annual
report, showing that its undistributed net investment income
exceeded 50% of total assets.
"If they've got a big number there," says Matt Forstenhausler, a
partner in the asset management group of accounting firm Ernst &
Young, "you should think, 'They could distribute that to me.' The
intent of these numbers is to give people an idea of potential
taxes, and I always check them before I buy a fund."
Think twice before buying a shrinking fund. Once the BT fund
shriveled in size, the year-end shareholders had to foot everyone
else's tax bill.
Buy index funds. Because these market-replicating funds rarely
realize capital gains, they are highly tax-efficient. That's
Reason No. 179 why long-term investors should have most of their
money in index funds.