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A Tax Cushion From Bear Market

Stock funds' losses will allow them to shelter some gains if Wall Street upswing continues.

June 25, 2003|Josh Friedman | Times Staff Writer

The long bear market may have left a gift for stock mutual fund investors this year: positive returns without the tax bill.

Many stock funds have built up losses on their books that can be used to offset fresh capital gains. That should allow the funds to avoid having to make significant taxable gains distributions to shareholders this year even if the market rebound continues, experts say.

In effect, investors who own stock funds in taxable accounts might get a free ride for a while: Their funds' shares may appreciate if the market advances, but they won't immediately owe tax on the gains, as is often the case in a rising market.

The tax shelter benefit could provide a buying incentive for investors who are optimistic about the market but have so far held back, some analysts say.

"This is one of the good parts about the aftermath of a bear market," said Don Cassidy, senior research analyst at fund tracker Lipper Inc. in Denver.

Technology sector funds, the biggest losers during the bear market, are among the portfolios in this potential sweet spot.

Some large diversified funds also have sizable tax-loss cushions, including growth-oriented portfolios such as Fidelity Aggressive Growth, Harbor Capital Appreciation, Janus Mercury and Vanguard U.S. Growth, according to fund tracker Morningstar Inc. in Chicago.

Many stock funds typically have such tax cushions after bear markets because the realized losses they have racked up, beyond any offsetting capital gains, can be carried forward for eight years to offset future gains.

Federal law requires funds to distribute net capital gains to shareholders each year, but funds aren't permitted to distribute losses; instead they must simply hang on to losses.

Industrywide at the end of April, stock funds had realized losses on their books equal to 24% of total assets, according to the Investment Company Institute, the fund industry's main trade group. That number may not be representative of the average fund, however, because some portfolios -- particularly aggressive-growth funds -- have accumulated especially steep losses over the last three years.

Janus Mercury, which lost 22.8% in 2000, 29.8% in 2001 and 29% in 2002, has snapped back under new manager David Corkins, with a year-to-date gain of 14%.

Mercury's portfolio has $398 million in net unrealized gains, but that is dwarfed by the $6.8 billion in tax losses on the books, Corkins said.

The losses are equal to 135% of the fund's current assets, and could allow Corkins to offset a like amount of realized gains before having to pay out taxable distributions.

"One of the things people hate about mutual funds is getting those statements at the end of the year showing distributions," said Corkins, who also manages the Janus Growth & Income fund. "I have a bunch of my money in both of my funds, and I hate paying taxes along with everyone else."

At T. Rowe Price Group Inc. in Baltimore, the firm's Science & Technology fund has losses on the books equal to about 165% of assets, said spokesman Brian Lewbart.

At Trust Co. of the West in Los Angeles, the TCW Galileo Aggressive Growth fund has an $80-million tax loss carried forward, worth more than 50% of assets, the company said.

Investors who are eyeing a stock fund can call the fund company to get a picture of its accumulated capital gain or loss status, Lipper's Cassidy suggests.

Of course, just because a fund has large embedded losses isn't by itself a reason to buy. If the market turns lower, or the fund is poorly managed, its losses may balloon further.

What's more, capital gains payments aren't an issue for investors buying funds for tax-advantaged accounts such as 401(k)s, because those investors don't pay taxes until the account is tapped.

TCW's tax director, Peter Brown, reminds investors that funds with accumulated losses offer "a tax deferral -- not a permanent tax savings."

Annual capital gains distributions automatically lower a fund's net asset value per share by the amount paid.

By contrast, when a fund with offsetting losses is able to hold on to its gains rather than pay them out as annual distributions, its net asset value per share will be higher over time -- which means there will be a larger taxable capital gain when the investor ultimately sells the fund.

Still, Brown notes, it's advantageous for an investor to "put dollars to work in pretax fashion," allowing an account's gains to compound over time. That also allows the investor to control when taxes are due.

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