Funds That Double Your Pain

This tax season, you may be feeling pretty cranky as you prepare to shell out taxes on the same funds that lost you money last year. You have every reason to be.

According to a study from Wiesenberger/Thomson Financial, last year saw the biggest, nastiest capital gains distributions in more than two decades.

In the same year that nearly half of U.S. equity funds lost money, 38 percent of them also distributed capital gains. The average distribution for a domestic equity fund was 9.19 percent — the highest distribution, as a percentage of net asset value, since at least 1979.

As ugly as the situation may seem, though, console yourself with the thought that it probably could have been worse. That's because the average capital gains distribution of 9.19 percent pales next to the worst-case scenarios. (Of course, if you own funds through tax-deferred accounts, you don't have to worry about the cap gains distributions.)

Unemployment Holding Steady, So Far

Exhibit A: According to Wiesenberger, a tiny, $2 million UAM Sterling Partners Equity fund socked investors with the biggest capital gains distribution, as a percentage of the fund's value, of any of the 6,087 U.S. equity funds in existence. It distributed a stunning 97 percent of its net asset value.

According to Morningstar, the fund is mostly held by institutions, not individual investors. But those shareholders can't be too happy: On top of the capital gains hit, UAM Sterling Partners Equity has struggled along in terms of performance, barely keeping its head above water in each of the past two years.

According to Wiesenberger senior analyst Ramy Shaalan, if you'd invested $10,000 in the fund at the beginning of 1999, you'd have ended year 2000 with only $10,187.

But because of massive capital gains distributions, your total taxes would amount to $4,966, assuming the gains were short term and that you pay taxes at the top rate of 39.6 percent. (Under new rules, the Securities and Exchange Commission has mandated that funds assume the highest rates apply when they determine how much investors would pay in taxes.)

To be fair, the good news about UAM Sterling Partner Equity is that it didn't actually lose money for investors. The fund just barely managed to finish in the black, up 0.83 percent in 2000.

Unemployment Holding Steady, So Far

But lots of other funds have left investors on the hook for whopping tax bills at the same time they suffered double-digit losses.

Take Apex Mid Cap Growth. Though it was up just over 42 percent in 1999, the fund belly-flopped last year, finishing down 75.96 percent. Also in 2000, it passed along distributions of 21.79 percent of net asset value.

If you'd invested $10,000 in 1999, your investment would have shriveled to $2,793 by the end of 2000. And for that privilege, you'd owe taxes (again, assuming the highest rates) for the two-year period of $1,350.

In the sucker-punch contest, Apex gets some competition from the ultra-volatile Warburg Pincus Japan Small Company fund. The fund scored lots of press in 1999, when it gained a stupendous 328.7 percent. But last year it dropped 72.10 percent, while distributing capital gains of 50.41 percent of net asset value.

According to Wiesenberger, a hypothetical $10,000 investment in the fund would have grown to $11,136 by the end of 2000, but you'd owe taxes of $6,469.

Luckily, most funds haven't incurred taxes on this scale, but it's still going to be a brutal tax season for lots of investors. So what's behind all the bad news?

According to Wiesenberger's Shaalan, part of the problem can be traced to the tiny cash stakes that funds held in the good times. Since the markets were so hot, fund managers kept all but a miniscule sliver of their assets invested in stocks.

By the end of the first quarter in 2000, the average equity fund was 98.99 percent invested in stocks.

Fast-forward to the spring, when steep market slides sent investors racing to get their money back. With so little cash on hand, managers found themselves forced to sell some of their holdings in order to raise the money to hand back to investors. Even though stocks had dropped in price, managers were sitting on big unrealized gains.

Some Good News

The upshot: Those embedded gains have now resurfaced as capital-gains distributions of the approximate size and weight of elephant seals.

To minimize your tax bills in the future, analyst Shaalan recommends searching out funds with solid tax-efficiency records. (You can find these details next to performance information on )

Also keep an eye on a fund's turnover record because funds that sell lots of stocks often end up with big tax bills, unless they're very careful.

Watch for the arrival of new fund managers, who may trigger taxes by overhauling portfolios established under their predecessors.

Finally, Shaalan cautions investors not to chase last year's winners. By snatching up last year's hot fund, you run the risk of buying into embedded gains without reaping the rewards that accompanied them.