Watch Out for Tax Time Bombs in the Fourth Quarter

The fourth quarter is a decent time to review your portfolio to see where you stand: There's the potential to squeak in 401(k) contributions so you can hit the limits, and you can also scout around for tax-loss candidates.

But making changes to your portfolio before year-end can also be treacherous, because we're coming into that season when mutual funds make capital gains distributions. New buyers of certain funds could find themselves in that worst-of-all-worlds situation, where they haven't enjoyed a bit of a fund's long-term gains but they've gotten socked with a capital-gains tax bill all the same.

Mutual fund firms typically give shareholders a heads-up about the capital gains distributions they're expecting to pay out; check your fund companies' websites in the weeks ahead for the latest estimates. If a capital gain is on the way and you're purchasing the holding for a taxable account, you'll probably want to delay your purchase until after the distribution date. (If you already hold a fund that's about to saddle you with a big tax bill, you'll need to weigh the benefits of selling pre-emptively against your own tax situation: You could dodge the fund's capital gains payout, but if you personally have a gain in the fund, you'll still owe taxes.)

Given the convergence of recent events, I think there's a realistic possibility that capital gains distributions could be meaningful for some funds this year.

With an eye toward identifying some fund types that could be most at risk of making big payouts, I started by using our  Premium Fund Screener to identify those equity funds that have potential capital gains exposures of 25% or greater. The strong market rebound since early 2009 means that many funds now have more gains than losses on their books: In fact, fully half of the equity mutual funds in our database have positive potential capital gains exposure, meaning that they have gains on their books that they haven't yet paid out to shareholders, and more than 200 stock funds have potential capital gains exposure of more than 50%.

A high PCGE statistic shouldn't automatically set off alarm bells, though. The key word behind this statistic is "potential"; if a fund doesn't sell the shares that have appreciated, it can have high PCGE but be very tax-efficient for years. You have to worry about impending capital gains payouts, though, when there is a catalyst for the manager to sell those long-held, highly appreciated positions. One such catalyst that looks relevant for many funds in 2011 is redemptions. We've been observing a trend of investors shifting money out of traditional mutual funds and into ETFs for the past few years, and I suspect that's likely to continue given active mutual funds' margin of underperformance thus far this year. Second, some fund types, especially international offerings, have seen significant volatility and real losses so far this year, and that could prompt some shareholders to vote with their feet.

Our screener doesn't currently let us to home in on those offerings that have been seeing the largest redemptions, so we layered on a screen for year-to-date losses as a proxy, reasoning that funds with sizable losses could be the most vulnerable to redemptions. Nineteen funds made it through the screen; Premium Members can click  here to run the screen themselves. Not all of these funds will necessarily pay out capital gains, mind you. In fact, though diversified emerging-markets funds dominate this list, they have continued to see strong inflows in 2011, so I'm less worried about them.

However, a few other categories appear to be at greater risk, particularly when you consider that they have already been seeing outflows in 2011. I've highlighted a few of the "at risk" groups below, and would also throw small- and mid-cap domestic funds onto the list, as many such offerings have been seeing redemptions so far this year. If you're considering buying a fund in one of these groups, that's a good argument for first scouting around for information about prospective distributions.

China Region
Despite robust gains of nearly 20% on an annualized basis over the past three years, funds in this fairly small group have hit the skids recently. Owing to concerns about rising inflation, a potential housing-market bubble, and several accounting scandals, the typical fund in the category has lost 17% so far this year, the highest drop of any category. That's apt to spook many of the category's newly arrived fundholders, who flocked to these funds after they posted a 65% average gain in 2009. Though recent performance may pique the interest of bargain-hunters, they may want to hold off on new purchases for their taxable accounts, given the potential for high capital gains payouts in the future.

Latin America
Latin America stock funds still have the best three-year annualized returns, on average, of any category, save precious metals. But Brazil, the region's largest market, has struggled mightily so far this year; the entire region has also foundered due to worries that slowing global economic growth could erode demand for the basic materials that are a key focus of the region's economies. As a result, Latin American stock funds land near the bottom of the equity-fund heap this year, and assets have been leaving at a good clip. As with funds in the China region category, that combination could force Latin America funds to sell long-held winners to meet redemptions, which in turn could trigger tax bills for shareholders.

World Stock
In contrast with the previous two categories, past gains in this group haven't been as explosive, so that could help mitigate the potential for capital gains payouts. Nonetheless, redemptions have been a problem for this category, so forced selling could prompt managers to let go of long-held winners. It's a broad category with varied strategies and performance histories, but it's still worth checking impending capital gains payouts before committing new taxable money to funds in this group. 

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