If you see a storm coming, you either prepare for it or tough out the consequences.
Look closely enough at some mutual-fund statistics published recently by Lipper Inc., and it’s hard to ignore the possibility that investors are facing a storm, one that is likely to catch shareholders both unaware and unprepared.
The building storm is evident in the trend of rising tax dollars paid by investors to Uncle Sam. According to Lipper, investors in taxable mutual funds paid the government at least $23.8 billion in 2006, simply for pursuing a buy-and-hold strategy.
Fund distributions for 2006 were at their highest level since 2000. That was the year when investors got flooded with payouts on funds that lost money, paying a hefty bill while suffering a downturn.
Now the fund world seems inexorably drawn to that miserable combination of events again.
Mutual funds are “pass-through” investments, meaning that the tax obligations of the fund are passed to shareholders, who are on the hook for them. So if a fund accrues capital gains by trading stocks, shareholders must pay the tax man for their share of the gains. (By comparison, an investor in an individual stock owes capital-gains taxes only when they sell their shares at a profit.)
There are worse things than receiving taxable distributions, like losing money. But taxes are a drag on taxable accounts, which is why investors might look for “tax-efficient” funds to hold there.
The looming problem comes from gains piling up over time inside a fund when the market is hot. When the stock market turns, managers close out long-term winners to lock in profits, creating a situation like 2000, when the bear market arrived. Funds suffered big losses but then paid out huge taxable distributions as an extra kick in the pants.
“I think people have forgotten how bad that was,” says Tom Roseen, the Lipper senior research analyst behind the tax study. “Capital-gains rates are lower now, and people are thinking there just won’t be the same kind of problem again.”
In 2002, lawmakers forced mutual funds to make investors aware of tax efficiency. It might have had an effect on investor behavior if average consumers actually read their prospectuses closely.
They don’t.
With four years of outstanding performance, the stock market has racked up big gains, and a lot of those profits have not been realized, despite the increasing distribution trend highlighted by Lipper. If the market takes a downturn and managers sell positions to protect their profits, the distributions paid out will dwarf current numbers. And there won’t be nice market gains to keep investors cheery.
Says Roseen: “We have been on a tax holiday for the last five years, when no one has cared about taxes. Now the distributions have gotten big, gains are building and if we have a year of subpar performance, you are going to see a lot of unhappy investors again.”
Of course, investors in taxable accounts might be unhappy just with taxes they paid on distributions in 2006, if they paid attention to their real impact.
The whole situation could be made a lot more simple if Congress would step up and embrace a bill that would allow investors to avoid capital-gains taxes on their funds until they actually sell their shares, essentially treating funds more like stocks from a tax perspective.
The proposal would save investors a bundle and actually has bipartisan support, but it doesn’t appear to be gaining steam. The Lipper study will help, but chances are that Congress won’t take action until there is another confluence of market losses and gains payouts to anger investors.
Chuck Jaffe is senior columnist for MarketWatch. He can be reached at jaffe@marketwatch.com or at Box 70, Cohasset, MA 02025-0070.
