Looking for Tax Bombs and Bouquets in Your Mutual Fund

There won't be many years like 2009. Fund investors earned returns in the range of 20% to 70% on equity and high-yield bond funds. Even better, most didn't have to pay capital gains taxes, either. Funds had big losses on the books from 2008 to offset realized gains in 2009, so they were able to avoid making distributions.

But if you're buying funds today, you ignore taxes at your own peril. A good chunk of those past losses have been worked off, and income tax rates are set to rise in 2011. You might get by for a year or two without being hit by capital gains, but stock funds are meant to be held for 10 to 20 years. If you're shortsighted about taxes, you could pay a price down the line. Each year, funds have to distribute any realized gains after subtracting past and current realized losses.

Here's the current tax situation for mutual funds: Morningstar estimates each fund's potential capital gains exposure by using a fund's annual report on its net gains and losses, adjusting them for appreciation or depreciation since then. It is expressed as a percentage of the fund's assets. You can find the figure on the Tax tab for each fund's page, and you can also screen on a certain PCGE level in the  Premium Fund Screener. Not many funds have released their year-end 2009 statements, so we're still adjusting from 2008 numbers. The figures aren't likely to be exact but should be in the ballpark. Typically, a fund will distribute a sum that's smaller than its PCGE, but there have been exceptions.

The picture is pretty good overall for the fund universe. Diversified foreign- and domestic-stock funds have an average PCGE between negative 20% and negative 40%. That's not really a good picture of the funds you might buy, though, because it includes some giant negative PCGE figures from funds with terrible performance. I ran a second screen on the funds in Morningstar FundInvestor's 500 funds list as a proxy for good funds that people should actually buy. As you can see from the table, that sliced the figures drastically. Three categories are now just about neutral on PCGE, and others are between negative 5% and negative 20%. If you place a heavy weighting on past three- and five-year returns, you probably are looking at funds with positive capital gains.

Let's take a quick look at some of the prominent funds with the highest PCGE. Many are funds that were closed near the 2007 peak and thus prevented investors from buying at the worst time. However, most funds have since reopened so it's not just an academic point. If you are considering buying one of these funds, see if you can add them in a tax-sheltered account like a Roth IRA so that cap gains won't matter.

The 10 Highest and Lowest PCGE Figures for M500 Funds

 T. Rowe Price Latin America (PRLAX) and  Vanguard Energy (VGENX) are at the top of the list--no surprise given their returns.  Gabelli Asset's (GABAX) low turnover and slight inflows are a recipe for a big PCGE.  Westport Select ,  Tweedy, Browne Value (TWEBX), and  Janus Venture (JAVTX) have all been closed for much of the past decade, though Westport has reopened.

Tax Bargains?
Now let's look at the Morningstar 500 funds with the largest negative PCGE. Interestingly, most of them had a brilliant 2009--this could be a pretty good contrarian indicator as it combines flows with returns.

 Janus Enterprise (JAENX) and  Janus Worldwide  have a lot in common. Ten years ago they were hugely popular and then took pratfalls that led to the giant triple-digit negative PCGEs. In the bear market the funds lost money and investors fled, leaving the funds with big losses on the books. At this point, both are intriguing plays, though you need a little faith given the managers' short records. Laurent Saltiel took over Worldwide this year but has a good three-year record at Janus International Equity . At Enterprise, Brian Demain has a good record, but it's only two years long.

 T. Rowe Price Science & Technology (PRSCX) is a similar story though it feels like even more of a gamble. Kennard Allen had a great first year on the fund with a 68% total return. But would I buy a fund that's just gone up 68%? No. That's coming to the party too late.

 Loomis Sayles Small Cap Growth (LCGRX) is far and away my favorite of this group. You've got a longer track record from the managers and the crummy past returns belonged to the previous regime. The fund's five-year returns are in the top decile of its small-growth peer group, but no one has noticed because the 10-year returns are still bottom decile. Why care when management took over in 2005?

Managers Mark Burns and John Slavik look for earnings sustainability and price momentum, thus making them half-aggressive, half-mild-mannered. They take risk down a notch with a strict stop-loss discipline that I would imagine has helped them navigate a brutal stretch for momentum stocks.

 Janus Research (JAMRX) was a different beast when it suffered its big losses. It used to be Janus Mercury, but now it's an analyst-run fund. So, it's a similar bet to the above Janus funds, only you're betting on analysts rather than one manager. Given the firm's overall strong performance, which must be partly attributable to the analysts, that could be a good bet.

 Vanguard U.S. Growth (VWUSX) has been a real albatross for Vanguard. It's got an outstanding record of selecting subadvisors everywhere but at this fund. More recently, new managers have brought performance up from lousy to middling. The current subadvisors are from William Blair and AllianceBernstein. This is one Vanguard fund that I have trouble getting enthused about.

The final two on the list are  Schneider Value  and  Fidelity Select Technology (FSPTX). They are decent funds, but after their big rallies in 2009, I wouldn't rush in.

Correction: In earlier editions of this article we mistakenly listed Oakmark Select (OAKLX) as having 34% potential capital gains exposure. However, the underlying capital gains reported in the September 2009 annual report had not been recorded. With that figure recorded, the correct number is 16%. In addition, we overstated the PCGE for Causeway International Value (CIVVX). The correct figure is negative 25%.

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