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Last Year's Losses Easing Capital Gains Distributions

Also, Bogle Small Cap Growth reopens, Peltz joins Legg Mason board, and more.

Morningstar Analysts, 11/02/2009

It's capital gains season, but despite this year's strong rally there still may not be many gains for funds to distribute. Heading into the final months of 2009, many mutual fund companies have either announced or are preparing to announce their funds' estimated capital gains distributions for the year. Dodge & Cox, Longleaf, and Baron Funds have said that they don't expect any capital gains distributions this year, and Osterweis has indicated that it expects minimal, if any, capital gains distributions for 2009. T. Rowe Price TROW also released its estimates, and the firm expects only a few funds to pay out small capital gains distributions. Fidelity's announcement also indicated very few capital gains distributions. This is in sharp contrast to last year, when many funds distributed gains realized in the runup to the bear market while the market was plunging. This year many funds are using severe losses sustained in 2008 to offset more recent gains. Funds can use those losses to offset future gains for as many as eight years. So, an upside to last year's debacle is that a lot of funds should be more tax-efficient in coming years.

Morningstar calculates funds' potential capital gains exposure on a monthly basis. PCGE estimates the percentage of a fund's holdings that represent gains, and it serves as a guideline for investors regarding the likely tax costs of investing in a fund. When considered with other factors, such as turnover and strategy, PCGE can help identify funds that might make big capital gains distributions in the future.

We looked at the potential capital gains exposure for the 25 biggest funds and found they fell into three buckets. Even though the market has roared back since early March, the bear market's impact remains evident in the fact that 15 of the 25 funds have negative potential capital gains exposure, meaning investors shouldn't expect any distributions, at least in the near term. Dodge & Cox's funds have the lowest potential capital gains exposure in the group: Dodge & Cox International Stock DODFX clocks in at negative 26.3% while Dodge & Cox Stock's DODGX is negative 23.0%.

The second bucket includes six funds with potential exposure in the low single digits, like American Funds Investment Company of America AIVSX at 3.3%. It should be relatively easy for managers with low-single-digit PCGEs to offset their funds' gains with losses.PAGEBREAK

Finally, four funds register slightly higher potential gains exposure, like American Funds EuroPacific AEPGX and Vanguard 500 Index Investor VFINX, at 15.8% and 11.3%, respectively. But given these funds' tax efficiency and their low turnover ratios, our guess is that investors in these funds won't feel much of a tax bite, if any. In fact, Vanguard 500 hasn't issued a capital gains distribution in a decade or so.

Bogle Small Cap Growth Reopens
Bogle Small Cap Growth BOGLX will reopen to new investors on Nov. 1. This Fund Analyst Pick had been closed to new investors since 2002. Assets at the fund reached a high of $157 million at the end of 2006 but stood at about $90 million at the end of September 2009. Manager John Bogle Jr. has managed this quantitative-driven offering since its 1999 inception and has a long history of managing quantitative portfolios. Although the fund stumbled badly in 2008, this year through Oct. 28 it's up 30.6%, beating 85% of its small-blend peers. It also held up well in the previous bear market and handily beats its peers since inception. This is a good chance for investors to get into a top small-blend fund.

Peltz Joins Legg Mason Board
Earlier this week, billionaire activist investor Nelson Peltz was named to Legg Mason's LM board after building up a 4.3% stake in the asset manager via his firm, Trian Fund Management. Peltz is widely known for amassing big stakes in companies, gaining a board seat, and then pushing for changes in management or strategy. So far, he hasn't indicated any major plans; Morningstar senior equity analyst Greggory Warren covers Legg Mason and noted in a recent report that "Peltz seems to be content with Legg Mason's recent strategic initiatives and has agreed to vote Trian's shares in favor of Legg Mason's current slate of director nominees."

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