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Mutual Funds
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| | Mutual Funds
Top funds may be too hot to handle
Mutual funds are making annual distributions to their shareholders. If you buy now, you could get burned by a tax bill you don't deserve.
By Timothy Middleton
You never chase performance, right? We've all been told it's a good way to lose money in mutual funds.
But even if you've ignored that advice in the past, heed it right now.
Mutual funds will soon begin making their year-end distributions of dividends and capital gains. If you buy a fund just before the distribution, youre buying a tax liability you dont deserve. This year, its apt to be huge, and the biggest payouts will come from the best-performing funds.
We saw in 2004 huge increases, and we think thats going to continue this year, says Tom Roseen, senior fund analyst for Lipper Inc., the fund consulting firm. The largest distributions are likely to come from value, small cap, international and energy funds -- Funds doing very well over the last two or three years, he says.
Some fund companies dont give shareholders much of a heads up on these payouts, but a few have released estimates, including the American Funds complex and T. Rowe Price. A spokesman for Fidelity Investments says its estimates are due out literally any day now.
American Funds New Perspective Fund A (ANWPX), which invests in domestic and international stocks, expects to pay out as much as 6% of its assets in distributions. Thats more than the fund's average annual return over the past five years.
An unwelcome return
Mutual funds themselves dont pay taxes -- they pass the burden to their shareholders. Most funds tax year ends Oct. 31, and distributions are paid in late December. Fidelity pays many distributions in November.
Related news and commentary on MSN Money
Investors typically reinvest dividends and other distributions, but that doesnt obviate their tax liability. A $500,000 portfolio whose average distribution is 3% of net asset value would owe taxes on $15,000.
Investors got a vacation from this fleecing during the bear market, because most funds racked up big losses rather than taxable gains. They continued to use those losses to offset gains in 2003, but last year their string ran out.
Short-term gain payouts were up 340% in 2004, and long-term gains were up 539%, Roseen says.
Theyll be up sharply again this year. Sam Beardsley, director of investment taxes for T. Rowe Price Associates, says. Were expecting a 35% to 40% increase over the prior year. We also have more funds that are paying (distributions), by almost 50%.
Short-term gains are taxed as ordinary income, at a rate twice the rate for dividends and long-term gains.
You have to make money to generate such gains, so funds that havent been doing well, such as large-cap growth funds, probably wont be paying any out. American Funds Growth Fund of America A (AGTHX) expects distributions of less than 2%.
Who gets hit
Since funds dont pay taxes, most mutual-fund managers ignore the issue and typically generate a bigger tax liability than would a privately managed account. One sign of tax inefficiency is heavy turnover -- above-average amounts of buying and selling -- which produces the most short-term gains.
Fortunately, the most widely held funds tend to have low turnover. Thats understandable; lower turnover signals fewer mistakes that have to be disposed of, which demonstrates managers are smarter than most, which means higher returns, which means more assets.
This year, it's a fund's category that will best indicate whether a big distribution is likely. T. Rowe Price Blue Chip Growth (TRBCX) is expected to pay no distribution. T. Rowe Price Small-cap Stock (OTCFX), in a better-performing market segment, expects a distribution equal to 4.8%. T. Rowe Price New Era (PRNEX), with big stakes in fast-rising energy and minerals stocks, estimates a payout of 5.9%.
| Selected T. Rowe Price estimated distributions | | Fund | Est. %
distribution (1)(2) | | Blue Chip Growth (TRBCX) | 0.0 | | Equity Index 500 (PREIX) | 0.0 | | Health Sciences (PRHSX) | 3.4 | | Small-cap Stock (OTCFX) | 4.8 | | Emerging Markets Stock (PRMSX) | 5.1 | | Mid-cap Value (TRMCX) | 5.2 | | New Era (PRNEX) | 5.9 |
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Notes: 1: Estimated distribution divided by net asset value (NAV) as of 9/30/2005. 2: Excludes income dividends paid quarterly.
Sources: T. Rowe Price, MSN Money
For new buyers, all pain, no gain
One category of investor doesnt need to worry about these payouts: the retirement saver. Qualified tax-deferred plans like 401(k)s and IRAs arent taxed until funds are withdrawn.
Another category, though, has to be particularly wary: the performance chaser. In the third quarter of this year, the bear market that ended in mid-2002 washed out of three-year performance comparisons, seemingly producing striking improvements in returns. For example, Vanguard Primecap Fund (VPMCX), which rose an average of 12.5% in the three years ended June 30, roared ahead 22.7% in the three years ended Sept. 30.
So expect a rash of ads touting these seemingly fantastic returns, which aim to stampede you into buying (now, before you lose out!). Vanguard is not an offender at this game, but many other complexes are.
And if you chase performance and work with a broker, youre wearing two bulls-eyes. Even though its foolish to buy ahead of these distributions, brokers have quotas to meet. If your broker calls in the next two months offering a hot fund but failing to mention the tax implications, you should find another broker.
That broker, if pressed, will say you cant allow the tax tail to wag the investment dog. Like all clichs, this has a kernel of truth. But these distributions have been earned by existing shareholders; newcomers get none of the benefit -- but 100% of the tax bill.
All you have to do to avoid that bill is to wait until after the distribution is made.
By the way: I usually get a rash of e-mails at the end of December from investors who check NAVs every night and have suddenly discovered sharp declines in the value of their funds. Relax: The value didnt change; the NAV went down because a portion of it was paid out. Youve still got the same amount of money. Youll get extra shares if you reinvest, or cash if you dont.
At the time of publication, Timothy Middleton owned the following securities mentioned in this article: T. Rowe Price Mid-cap Value, T. Rowe Price New Era, T. Rowe Price Small-cap Stock.
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