Mutual Funds: Big Losers Can Be Big Tax Shelters

Some strong funds have taken a beating--which makes them worthy tax-efficient plays for intrepid investors

By Lewis Braham

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Fogelson-Lubliner

If there's a silver lining to 2008's dismal bear market, it's that many investors likely won't have to pay any taxes on gains in their stock mutual funds for years to come. By law, funds must distribute any taxable gains realized each year from selling appreciated stocks, but they can't distribute their losses. Those stay on a fund's books and can be used to offset future gains, and so eliminate or minimize the need for a fund to make taxable distributions to shareholders.

This also means new investors can benefit from previous investors' pain by buying good funds with large losses on their books. Good funds with large losses? That may sound like an oxymoron, but last year's decline spared virtually no one, and some of the best funds have effectively become massive tax shelters. Top-performing funds such as Dodge & Cox International (DODFX), Hartford Capital Appreciation (ITHAX), and Janus Contrarian are all sitting on sizable losses that will shield investors from taxable distributions for years.

Investors searching for good funds with big losses can start with the "capital gains exposure" stat for funds on Morningstar.com (MORN). It quantifies, based on estimates of returns and assets, a fund's gains or losses as a percentage of assets. This is one of the few cases in investing in which a negative number is a good thing. Take Dodge & Cox International. It has a -80% capital-gains exposure, meaning it has a capital loss that covers 80% of assets. So it could have several years of tax-free gains.

Generally, the smart strategy is to buy a bigger fund so that losses are harder to dilute with new money. If the fund is small, check on Morningstar.com or on the fund family's Web site to see whether the fund or fund family has a history of closing funds before they get too big. Bridgeway and Wasatch are good examples of fund companies that tend to close their funds at small sizes.

Dodge & Cox International is a $25 billion fund, so it would take a lot of new money to dilute the losses it has to offset future gains. As with any fund, low expenses and good long-term returns are key. Dodge & Cox has a low 0.65% expense ratio and a record of having beaten more than 70% of peers over the past five years.

THE LONG VIEW

There are caveats. "Morningstar's capital-gains number is correct for what it's estimating but doesn't tell you how a fund is managed with respect to taxes," says Joel Dickson, a tax specialist and fund manager at Vanguard Funds. "Often, capital losses in a fund will only last maybe five to seven years before they run out. That's not good for a long-term tax-efficient strategy over a person's lifetime." So even though a fund Dickson co-manages, Vanguard Strategic Equity, currently has a 72% loss exposure on its books, he does not recommend it for taxable accounts. "We're very clear in Strategic Equity's prospectus that tax ramifications are not taken into account in the daily management of the fund," he says. Although Vanguard's index and tax-managed funds currently have smaller loss percentages, Dickson recommends taxable investors stick with those.

The main reason Vanguard Strategic Equity is not tax-efficient is that it trades a lot. Appreciated stocks tend to be sold and thus produce taxable capital-gains distributions. While such gains are unlikely now, they'll occur when times are good. Although not managed with an eye to taxes, Dodge & Cox's funds practice a buy-and-hold strategy. Morningstar's site shows that they have low turnover ratios, typically holding stock positions for at least five years. That should make them tax-friendly over time.