Huge unrealized losses can turn funds into tax havens

The “double whammy” that plagued stock mutual funds last year – big losses and capital gains taxes – is partly responsible for a silver lining in this year’s stormy market.

Many funds are now sitting on enormous unrealized capital losses, which could turn those funds into tax havens because future returns will be partly sheltered from capital gains taxes.

“Great God almighty,” says Michael Fitzhugh, a principal at Kochis Fitz Tracy Fitzhugh & Gott Inc., a San Francisco-based financial advisory firm with about $500 million in assets.

“What would be really smart is for some company to buy one of those funds just for their losses. They could use the losses to offset gains for years,” he says.

Of course, that is a mixed blessing. The funds with the biggest losses are also the biggest dogs.

“Most people would probably rather see their portfolios go up 30% and have to pay huge distributions than see their portfolios go down and not have to pay taxes,” says Scott Cooley, a mutual fund analyst at Morningstar Inc., the Chicago fund tracker. “But at least it’s better than last year,” he says.

Changing landscape

Indeed, many investors last year found themselves in the unfortunate position of having to pay taxes on double-digit distributions on funds that churned out low or even negative returns.

This year, the landscape is much different.

For starters, many funds – particularly growth funds – now actually have a negative capital gains exposure, which means the average stock in the fund’s portfolio is being held at a loss.

Unlike capital gains, net losses can’t be passed on to shareholders. But funds can use them to reduce taxable gains for up to eight years in the form of a tax loss carry-forward.

Buying into a fund with a sizable capital loss exposure offers investors a cushion against future capital gains – in some cases a very big cushion.

Consider, for example, the $4.5 billion Vanguard Capital Opportunity fund, which had a potential capital gains exposure of -43% Sept. 30.

In other words, if the fund had been liquidated on that day, its holdings would have been worth 43% less than what they cost, according to Morningstar.

An even more extreme example is the Jacob Internet Fund.

As of Aug. 31, the former high-flier had $188 million of realized losses and $21.5 million of unrealized losses, according to documents filed recently with the Securities and Exchange Commission.

That’s a lot of losses for a fund that had only $17.1 million in assets under management at the end of August.

The numbers are so out of whack that Morningstar doesn’t even bother to calculate the fund’s potential capital gains exposure.

“There’s a real tax benefit to that one,” Mr. Cooley says of the Jacob Internet Fund. “That basically tells you the fund can rack up some enormous gains over the next few years and still not pay out distributions.”

Maybe so, but the fund’s horrendous investment performance far outweighs any potential tax benefit.

Jacob Internet Fund was down 60.66% and 74.38%, respectively, for year-to-date and 12-month periods as of last Tuesday, according to Morningstar.

For the year through Oct. 31, the average technology fund – including the Jacob Internet Fund – had a capital loss exposure of 156.36%. Thus the holdings could more than double from their current level without triggering tax liability.

The big picture: The average U.S. equity fund had a capital loss exposure of 22.50%.

“I think it’s pretty safe to say that most investors won’t be getting hit this year by the double whammy of negative returns and tax distributions,” says Duncan Richardson, chief equity investment officer at Boston-based Eaton Vance Corp. and manager of the $6.5 billion Eaton Vance Tax-Managed Growth Fund.

While many fund companies have yet to announce whether they will be distributing gains for specific portfolios, the year is shaping up to be a relatively mild one in terms of distributions.

Gains down

Through Nov. 9, the average domestic stock fund distributed 0.34% of its assets in the form of capital gains, down substantially from 6.87% and 4.96% in 2000 and 1999, respectively.

Of the 763 funds that have already made distributions, the average distribution amounted to just 2.85% of assets, down from 9.98% and 6.65% in 2000 and 1999, respectively.

Stephen Gorman, president of Gorman Financial Management Inc. in Hingham, Mass., is now in the process of reviewing each of his clients’ holdings for ways to harvest losses and minimize tax consequences. For him, and for many advisers, it’s an end-of-the-year ritual. “Projected distributions are negligible,” he says. “It’s highly likely that some clients will have a carry-forward for next year.

Mr. Gorman, whose firm oversees about $100 million in assets, pays close attention to a fund’s potential capital gain exposure before moving a client’s assets from one fund to another.

“I certainly wouldn’t jump out of one fund and into another with an unrealized capital gain position,” he says. “What I save this year, I may pick up next year.”

Of course, investors are paying a hefty price for their freedom from capital gains distributions – miserable investment results.

The average domestic stock fund was down 15.82% year-to-date through Nov. 9. For the one-, three- and five-year periods, the average fund returned -16.53%, 4.63% and 7.85%, respectively.

Growth funds really took it on the chin, with the average large-cap-growth fund down 26.47% year-to-date. Over the one-year-period, the average growth fund lost 31.41%. But it gained 0.13% and 7.06% over the three- and five-year periods, respectively.

“Clearly, nobody has been treated that well,” says Eaton Vance’s Mr. Richardson.