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August
15, 2002, 9:00 a.m.
A
Mutual Attraction
The
stock market creates some unusual tax-advantaged funds.
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or
those who believe that the U.S. economy will grow again, the stock-market
dive over the past two and a half years has created some unusual opportunities
for taxable investors who invest in mutual funds. An investment strategy
that can avoid the annual tax imposed on mutual-fund capital-gains distributions
can really make a difference in increasing long-term returns.
First of all, Uncle
Sam penalizes investors when their mutual fund manager incurs capital
gains each year. Come tax time, an investor must pay taxes on those realized
capital gains even though they may not have experienced the related gain
in their portfolio. If it is a short-term gain, the tax is equivalent
to their maximum personal income-tax rate; if it is a long-term gain then
the tax is at the capital gains tax rate.
Moreover, investors
don't benefit from realized capital losses in a mutual fund — these
losses can't be distributed to reduce an investor's tax liability. And
over time, such tax liabilities can reduce returns by more than 30% of
those advertised by mutual funds.
Some politicians
have recognized the unfairness of taxing capital gains in mutual funds
but the probability of tax relief in this area is limited. Therefore,
investors should seek out other investment strategies to keep this tax
liability from inhibiting their efforts to build wealth.
The stock market
decline has been especially painful for growth stock mutual funds. One
example is the Fidelity Aggressive Growth Fund. Morningstar, a well-known
fund-rating company, gives this fund a one-star rating for one-, five-,
and ten-year periods ended June of 2002. That's the lowest rating a fund
can have and the Morningstar analyst following the fund suggests "steering
clear." I don't think you will find this fund in any full-page Fidelity
advertisements. From a high point of $68.24 in February of 2000, the fund
has recently traded at $10.76.
Yet, this fund —
and others like it — offers an unusual opportunity for avoiding taxes
on capital-gains distributions. During the current market decline, the
fund incurred substantial realized capital losses, both short and long
term, as tech stocks plummeted and as investors fled the fund. At one
time, the fund exceeded $14 billion in assets. Recently those assets shrank
to under $6 billion. In the process, the fund incurred capital losses
that exceed 300% of the value of the fund. In other words, a new investor
could experience future recognition of capital gains in this portfolio
without paying any capital gains taxes until the fund fully offsets the
300% of unrealized and realized losses. Now that's a tax-advantaged fund!
What are the chances
of making money in a fund with a one-star rating? It depends on the stock
market. First of all, the fund responded well in the fourth quarter of
2001, rising almost 30%, and the fund increased over 100% in 1999 —
during two stock market advances. So, when the market turns, there could
be a comparative rally in this fund. Also, the fund manager is experienced
and has a solid academic background consisting of an undergraduate degree
from Stanford and an M.B.A. from Harvard. One risk is that he "loses"
management responsibilities for the fund through no fault of his own.
This is just one
example of a fund that might protect an investor from the taxman. Just
by postponing the realization of capital gains into future periods, the
earnings on those deferred taxes can be substantial. Given the recent
market shakeout, I'm sure there are many other funds with similar "tax-advantaged"
characteristics. For investors who want to dig deeper, reading a fund's
annual and semi-annual reports can provide the necessary insight to make
a timely investment decision and to keep Uncle Sam from taking a share
of your capital until it is due.
—
Tom Nugent is executive vice president and chief investment officer of
PlanMember Advisors, Inc. This analysis is not a recommendation of this
fund; it is only an example of potential opportunities in mutual funds
with large realized capital losses. The Fidelity Aggressive Growth Fund
is not a recommendation of PlanMember Advisors, Inc., nor is it held in
any personal accounts of Mr. Nugent.
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