Nobody likes taxes. It doesn’t matter whether it is property, school, local, city, county, or state. Everyone knows how much the president hates taxes as well. His efforts at cutting them continuously at the federal level have in most cases increased all of the aforementioned levies. But shouldn’t your investments and those that manage them harbor the same disdain for taxes?

Learning that your mutual fund can betray that confidence with little more than a change in management at the top can be downright disheartening. Disguise it to make it seem like a windfall and you are doubly stung with the reality that all the good things that come from investing such as returns and profits may have an equally malignant dark side.

When mutual fund managers leave, they do so for numerous reasons. Often they are lured by the brash profiteering they can achieve at the hedge fund level and the sheer amount of fun they can have trying to manipulate their reputation into profits for their clients or perhaps their exit came because they simply didn’t cut it, failing to beat the market and/or investor expectations. No matter the reason, when the head of the fund leaves, the fund goes through some changes. 

Many of the investment remodels are for the good and do take some time to work their way through the system especially in the case of an underperforming fund. But other changes are not so customer friendly.

Exiting fund managers may have an investment style or outlook that may or may not ascribe to the new taste of the freshly minted head of the fund. In an attempt to change the direction of the fund, by adding their own personal touch to the portfolio, a new fund manager may unload a good deal of the old portfolio rearranging the entire make-up of the investment. An investor can only hope that their new fund chief sticks to the charter you agreed to initially.

Those sales, when done correctly can add value to the fund. But when the fund manager jettisons holdings with a good deal of profit built up, and doesn’t balance those sales with the sales of holdings that have lost value, the consequences are not good for the shareholder. 

When this happens, there are taxes to be paid on the gain. When these distributions are made to investors who hold these funds outside of a retirement account, what at first might seem like a windfall can suddenly turn ugly once they realize the tax consequence. 

Burdened with this unexpected tax, the investor begins the search for offsetting losses or worse, the unfortunate sale of other assets with gains. All of this leads to the inevitable disbelief that the fund you have invested in has betrayed you somehow.

With the average fund manager staying at the top falling to an all time low of less than four and a half years, the chances of this happening to you have grown. Your fellow shareholders, some of who may have been more actively monitoring any the changes in the fund, learning about the possibility of such a change usually has them scurrying for the door. With these more diligent investors selling their holdings in advance, the news of a change only adds to the burden borne by the remaining investors.

Now while not all of us have the same due diligence required to short shrift your fellow investors in such a callous way, there are some things you can do should this happen to you.

If you have already locked away a nice long-term gain, a sudden distribution will not have an overall negative effect on the performance of the fund. Oddly, a distribution does not represent an increase in net asset value. Instead, because the fund has changed its holdings the fund’s value will have actually dropped, in some case significantly. 

If you are familiar with the new fund manager, research her or his historic turnover. If they do not have any noteworthy experience, look at the funds turnover rate going back one, two and possibly even five years. This information is found in the prospectus – the one you seldom read once you buy in.

For funds that do not index their holdings, it is not unusual to find higher turnovers, often over 100%. As a guide to measuring this ratio, fund managers that turn their portfolios over completely in a given year will exhibit a higher tax bill that will have a negative effect on performance. Newer managers can turn their portfolios at a much higher rate, often in as little as six months, generating short-term gains with short-term tax rates.

Growth funds, the ones most likely to have a high turnover – although some value funds are as guilty of shopping and dropping, should be expected to have a less-than-optimum tax efficiency. Which is why these types of funds should be held inside your tax deferred account. 

(The only exception comes when these funds make distributions that could be considered long-term profits qualifying you for the 15% tax rate; short-term sales of stocks held less than a year are taxed as regular income. In a fund with a high turnover, expect the worst tax treatment.) 

There are telltale signs that distributions may not be as bad as they seem. Look in the funds annual report for carryforwards. These are tax tools designed to offset profits by using previous years losses against the profit incurred by any unexpected shift in the portfolio.

Trouble is, funds don’t usually announce distributions too far in advance of the actual event. If they did, the impact on the NAV would be much higher. 

Prudent investors would do well to monitor not only your fund’s performance (which, if it has done poorly over the last two years is likely to see a change at the helm) but the tenure of the manager as well.

Or, they could simply keep their tax efficient funds, such as indexes, outside their retirement portfolios. These funds rarely switch managers, rebalance holdings infrequently, and tend to beat both growth and value over the long-term. 

© 2006 Paul Petillo
Editorial Archive

CONTACT INFORMATION
Paul Petillo
Blue Collar Dollar.com
Portland, OR USA
(501) 313-5252
Email  |  Website