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For Investors, Time to Think About Swapping Funds

Dumping laggard mutuals for others with greater promise could bring taxpayers a bonus.

November 04, 2002|Josh Friedman | Times Staff Writer

For stock mutual-fund owners, it's swap meet time: that time of year when it makes sense to consider swapping poorly performing funds for better ideas.

And given the long bear market, a portfolio-cleaning this year could pay a bonus. Investors may be able to dump lousy funds for others with greater promise if the market recovers in 2003, while getting a break on taxes by turning paper losses into realized ones.

In a bull market, stock-fund shareholders at this time of year normally would be sweating the annual November and December tradition of capital gains distributions, when funds are required to pay out their realized gains. But this year, taxable gains payouts should be rare, given the market's dive for most of this year.

That gives investors freer rein to consider upgrading their portfolios in the next two months by selling disappointing funds and replacing them with potentially better ideas for the longer run.

And if a fund is held in a taxable account, Uncle Sam will help: Realized losses on funds can be used first to offset any capital gains an investor may have realized, and then to offset ordinary income, up to $3,000.

"It always makes sense to improve your portfolio, and if you have a loss that's like icing on the cake," said Roy Weitz, a self-appointed fund industry gadfly who founded the Tarzana-based Web site

"With a 'sideways' trade, you can reestablish your position in the same market sector and have the government subsidize your move a little bit. If you're in a taxable account it's kind of a no-brainer."

As an example, Weitz said, an investor could sell a laggard large-cap growth fund such as MFS Emerging Growth (down 20.6% a year in the last three years) or Vanguard U.S. Growth (off 25.5% a year in the same period), and put the proceeds into Bramwell Growth, a large-cap growth fund that has performed far better during the bear market, losing 6.4% a year over the last three years.

Of course, just because a fund has held up better than its peers in the bear market doesn't necessarily mean it will excel if the market recovers.

But a bear market can expose professional stock pickers' weaknesses. For fund owners, it's worth asking whether they can do better with new managers.

Doug Fabian, editor of the Successful Investing newsletter in Huntington Beach, said investors need to guard against complacency even though the market overall has been dispiriting.

"I'm encouraging investors to be more active with their fund portfolio," said Fabian, whose Web site,, maintains a quarterly "lemon list" of laggard funds. "It's like tending the garden -- it needs maintenance."

Through last week, the average U.S. stock fund was down 20.7% year to date and an annualized 7.1% over three years, according to fund tracker Morningstar Inc. in Chicago.

By making a switch right away within the same fund category, investors can stay exposed to the same segment of the market, so they probably won't have to watch in agony if their former fund roars back to life. Major stock market indexes have advanced for four consecutive weeks, raising new hopes that the bear market may finally have run its course.

It never makes sense to let the tax tail wag the investment dog, as the experts say, but realized capital losses can be of significant help to taxpayers.

Investors can use a loss to help shelter the taxable portion of a gain from a home sale, for example, said Philip J. Holthouse, partner in the Los Angeles tax law and accounting firm Holthouse Carlin & Van Trigt.

Losses that exceed realized capital gains can be written off against regular income, up to $3,000 per single taxpayer or couple filing a joint return. (If spouses file separately, the limit is $1,500 each.)

Because regular income, such as wages, dividends and interest, is taxed at a higher rate than capital gains, a $3,000 capital loss applied against regular income can come in handy. For a California taxpayer earning $50,000, a $3,000 capital loss works out to about $1,100 in combined federal and state tax savings, Holthouse said.

In addition, losses beyond $3,000 can be carried forward indefinitely. So if you were unfortunate enough to plow, say, $200,000 into an Internet stock fund two years ago, you might have a lifetime worth of write-offs available if you sell the fund.

Even investors who have been in funds since the earlier days of the 1990s' bull market might have surprising paper losses, said Russel Kinnel, director of fund analysis at Morningstar. Investors who reinvested their annual capital gains distributions over the years may have a higher "cost basis" for tax purposes than they realize because those reinvestments were used to buy more shares as prices rose.

The fund-swapping strategy carries numerous caveats, however:

* In a tax-deferred retirement account such as a 401(k), it's pointless: Just as gains don't hurt you, tax-wise, in those accounts, losses don't help.

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