Mutual Funds Gear Up For SEC Tax Deadline

by Carla Johnson, Investors Offshore.com

02 August 2001

According to fund tracker Morningstar Inc., many US mutual funds are already gearing up for the February 2002 deadline set by the Securities and Exchange Commission (SEC), after which they will be obliged to disclose after-tax returns in their prospectuses.

Whilst this is not exactly the end of the world- after all, Morningstar and others have been providing after-tax fund data for years- recent events have meant that investors in poorly performing funds, and even those lucky souls invested in funds which have seemingly done well in comparison with their peers, are finding the tax bite uncomfortably large. Last year was especially bad, because many funds sold profitable holdings in early 2000, thus locking in capital gains as the market fell and the value of their funds spiralled downwards throughout the year. The end result, negative returns and a whole pile of taxable capital gains distributions, has undoubtedly prompted many investors to shift money to designated 'tax effective' funds, and more look set to follow as the true extent of the damage becomes clear.

Some funds, for example the Armada Mid-Cap Growth Fund, which was forced to sell profitable tech stocks at an inopportune time last year in order to retain its mid-cap status, have taken precautions to ensure that the downward spiral does not begin again, as in less than a year, it will be documented for shareholders and potential investors alike to see. Although the fund doesn't technically invest in companies with market capitalisation exceeding $20 billion, there is now a 5% section of the fund earmarked for companies above that level. 'It's essentially a get-out-of-jail-free card,' explained the fund manager, Alex Vallecillo.

Other funds are beginning to pay closer attention to the tax implications of their actions for investors, either deferring capital gains by holding shares for longer periods of time, or intentionally realising losses to offset capital gains. However, Russ Kinnel, Director of fund analysis at Morningstar, believes that fund managers would do better to explicitly state their tax policies, rather than merely revealing their after tax returns: 'The SEC should ask "Do you take taxes into account? And if so, how and when?"' he observed. 'That's a far better predictor of future tax efficiency. Not how they did it in the past.'

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