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August's Mutual Fund Red Flags

These manager changes could spur tax headache.

Gregg Wolper, 08/21/2007

Morningstar's fund analysts cover 2,000 mutual funds. Their full analyst reports, including Stewardship Grades, are available in Morningstar Principia Mutual Funds Advanced and Morningstar Advisor Workstation Office Edition.

This article originally appeared in Morningstar FundInvestor, an award-winning newsletter that presents investment strategies and tracks 500 funds.

When a fund changes managers, it makes sense to re-evaluate its prospects, whether you already own it or merely are thinking of buying it. Sometimes the new manager is less experienced than the previous leader. Conversely, at times the new manager has a longer record--and a better one--than his predecessor. Moreover, there's the style issue to consider: Whether or not the new manager is talented, if the fund changes strategy, it may duplicate a style you already have more than enough exposure to.

A different factor, though, is rarely considered by most investors when there's a manager change: Will the fund make a huge capital gains distribution as a result of the switch? It's not an esoteric question. Though there are exceptions, when a new manager comes in, the portfolio typically changes significantly. Occasionally there's a wholesale overhaul. If capital gains have built up in the holdings that the new manager sells, the fund's shareholders will owe taxes on those gains next April.

Because of this chance for an unpleasant tax surprise, it makes sense to tread cautiously when evaluating funds that have (a) substantial potential capital gains exposure built up in their portfolios, and (b) a 2007 change of management that is likely to result in a good deal of portfolio turnover. Here are three funds that fit that pattern.

Oppenheimer Developing Markets ODMAX
Potential Capital Gains Exposure: 44%
In one of the most surprising manager changes of 2007, Mark Madden left Oppenheimer--and thus this fund--in May. Madden had arrived just three years earlier from Pioneer, where he had racked up an admirable record over a decade at the helm of that shop's emerging-markets fund. Replacement Justin Leverenz has been a senior analyst at Oppenheimer's global fund, so it's not guaranteed that there will be dramatic changes in the composition of the portfolio--as there almost surely would be if the new leader had come from the outside. Even so, Leverenz does plan to reduce the overall number of holdings in the portfolio. And with a large capital gains exposure built up, it's quite possible enough changes will take place to create a significant tax bill.

T. Rowe Price International Stock PRITX
Potential Capital Gains Exposure: 36%
T. Rowe Price announced that Bob Smith, who currently runs T. Rowe Price Growth Stock PRGFX, is going to take over this fund in October, with one comanager staying on board but two others departing. Although many T. Rowe funds use the same general approach, Smith, as an experienced, respected manager being shifted to a rather unimpressive mutual fund, is unlikely to simply let the portfolio sit intact. In fact, he has said he plans to cut the number of stocks in the portfolio, and the fund will also change in a more subtle way, with it being viewed as one broad international portfolio rather than a collection of choices from regional managers. Given that Smith won't take full control until October, it's possible most of the taxable changes won't take place until the next fiscal year has begun. So, it might not be safe to get in until 2009.

Harbor Large Cap Value HILVX
Potential Capital Gains Exposure: 34%
Jeff Shaw, whose performance had not been impressive relative to rivals in the past few years, was replaced by Rick Helm in June. This fund could undergo a complete overhaul, for while both managers are value-oriented investors, their approaches are not identical by any means. At the most basic level, new leader Helm is more focused on companies that will be increasing their dividends. And based on his actions at other funds he ran, he could well double the size of the portfolio to 60 or 70 stocks. Such changes could easily trigger significant capital gains here.

Gregg Wolper is a senior analyst with Morningstar.

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