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Despite Rise, Stock Funds Could Avoid Capital Gains

October 07, 2003|Josh Friedman | Times Staff Writer

Stock mutual fund investors have a good shot at winning twice this year: Stocks are up sharply, but that probably won't translate into taxable capital gains distributions for most fund owners.

Many funds are sitting on accumulated losses from the 2000-02 bear market. Portfolio managers can use previously realized losses to offset newly realized gains, so they may have no net gains to distribute to their shareholders toward year-end.

"We would be very surprised if there is any substantial capital gains pickup this year," said Brian Reid, senior economist at the Washington-based Investment Company Institute, the fund industry's trade group.

Capital gains payments irk many investors because they mean a tax bill in the spring -- even though most fund owners reinvest their distributions rather than taking them in cash.

Investors who own funds in tax-sheltered accounts such as 401(k)s and IRAs don't face the tax issue, but it has long been an irritant for investors who hold funds in regular accounts.

Indeed, some in Congress have introduced legislation to allow fund investors to delay recognizing gains distributions until they sell shares, but the proposal has repeatedly stalled.

Stock and bond funds are required to pay out to shareholders any net realized gains each year. By contrast, the funds aren't permitted to let investors share in losses in down years. However, the funds can carry previous losses forward on their books for seven years to offset any new gains.

This year, the average domestic stock fund surged 18.3% in the first nine months, according to Morningstar Inc. But that follows three years of losses.

Analysts warn that in niche fund sectors that have been hot for several years, capital gains payments still are possible.

Buying such a fund before payments are made -- typically in November or December -- could mean buying an instant tax liability, said Tom Roseen, research analyst at Lipper Inc. in Denver. Investors who are shopping for such funds have to weigh the tax issue against the potential for a fund's share price to rise further in the near term.

"This is a great time to ask those questions of your fund company," Roseen said.

Fund categories in which distributions could be coming, he said, include precious metals, up 26.8%, on average, in the first three quarters and up 36.2% a year in the last three years; real estate, up 24.7% this year and 13.6% a year in the last three; and small-cap value, up 23.1% this year and an annualized 10.7% in the last three.

Roseen also warned that newer funds that have no bear-market losses could be forced to make distributions this year, depending on their performance.

So investors shopping for funds in the technology sector -- up 37.4% in the first nine months, on average -- might be advised to "look for one that's been around and has some losses on the books," Roseen said.

Major fund companies are finalizing distribution estimates. For most funds, the fiscal year ends Oct. 31 and gains are paid in November or December.

At T. Rowe Price Group Inc. in Baltimore, a handful of stock funds will make distributions this year, but in most cases they will equal less than 2% of net asset value per share, said Sam Beardsley, vice president of investment taxation.

Among bond funds, distributions will be more common but also generally very small, said Beardsley and his counterparts at rival firms. But one fixed-income fund that is likely to have a "significant" distribution is T. Rowe Price International Bond, which gained 11.9% in the first three quarters, Beardsley said.

At Vanguard Group in Valley Forge, Pa., only two stock funds -- Equity-Income and Energy -- had realized capital gains "of any significance" through September, said spokesman Brian Mattes, who expected those distributions to be less than 1% of net asset value.

At Fidelity Investments in Boston, distribution estimates will be posted on the firm's Web site in mid-October, spokesman Vin Loporchio said. "In general we expect funds that have been in existence through the bear market will have little or no capital gains to distribute," he said.

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