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Now May Be a Terrible Time to Invest

More than 90 million fund investors in America agree that mutual funds can be a superior investment vehicle.

Heck, a simple market-tracking index fund guarantees you the market's return -- historically 10% per year. That means that an initial investment of $25,000 will turn into $1.1 million over the course of 40 years -- without having to put in hours of research.

Convenience is king
Funds are convenient. They leave the stock-picking to paid professionals, while providing instant diversification. Take the Fidelity Growth Discovery (FDSVX) fund, for example. Buying shares of this fund gives you exposure to stocks large and small, domestic and foreign -- Google (Nasdaq: GOOG  ) , Cisco Systems (Nasdaq: CSCO  ) , Reasearch In Motion (Nasdaq: RIMM  ) , EMC (NYSE: EMC  ) , and Dell (Nasdaq: DELL  ) , as well as international firms Nokia (NYSE: NOK  ) , ABB (NYSE: ABB  ) , and Nintendo (NTDOY.PK). All these stocks appear in the fund's top 25 holdings.

Manager Jason Weiner has been with Fidelity since 1991, guiding this fund to a remarkable track record -- it's up 25% year to date. That's more than 19 percentage points better than the S&P 500 index. With a talented management team, low fees, and that kind of performance, Fidelity Growth Discovery looks like a potentially great investment.

However, now may be a bad time to invest.

Hi, I'm Uncle Sam
See, most mutual funds distribute income and net capital gains to shareholders in November or December. The profit from the sale of these securities is taxed, whether or not individual investors sell their fund shares.

If your fund shares are in a taxable account (i.e., outside a 401(k) or IRAs), you'll owe Uncle Sam if the fund manager sells investments at a profit.

This poses a problem for fund investors who make initial purchases near the end of the calendar year. They'll immediately receive taxable income without having been in the fund long enough to enjoy the gains that brought those taxes!

It's estimated that 2007 will see a significant rise in capital gains taxes, in part because of market volatility. With the housing and subprime meltdowns, fund managers traded more frequently, perhaps as a flock to quality.

Now, I said it may be a terrible time to add new money. There are two important caveats to note. For one, as master fund manager Ron Muhlenkamp has said, the tax tail shouldn't wag the investment dog. While taxes should certainly be a factor, they shouldn't be the sole basis of a buy/sell decision. It just so happens that November and December are the year's two best months to invest.

Also, not all funds will stick you with a giant tax bill. But the better-performing categories and funds (see: international-focused funds) will likely have large capital gains distributions this year.

On-the-ball investors, listen up
There's a simple workaround here: To avoid a tax hit, consider waiting to open a new stake in a fund until the new year. (This does not apply to current fundholders adding new money, of course.)

And while you're waiting, consider re-evaluating your portfolio to get ready for next year.

Identify sectors or asset classes in your portfolio that may need more (or less) exposure. Depending on the previous year's best performers, you may want to minimize your exposure in one group and bulk it up in another. A simple year-end portfolio review allows you to maintain proper diversification.

The Foolish bottom line
Mutual funds are convenient investment vehicles that can provide superior returns -- if you're wise in your approach.

The devil's in the details, though. With income and capital gains distributions imminent, make sure that your tax hit won't be too significant if you decide to invest. You can check the schedule and amount by calling the fund company or going to its website. (Fidelity Growth Discovery's distribution occurs in August and December.)

Avoiding unnecessary taxes and re-evaluating your portfolio each year are just a few of the Foolish tips covered in Champion Funds, the Fool investment service dedicated to beating the market with funds.

You can see all our recommendations, research, back issues, and model portfolios for free with a 30-day trial. Click here to give it a whirl -- there's no obligation to subscribe.

Claire Stephanic does not own any of the stocks mentioned. Dell is an Inside Value recommendation. Dell and Nintendo are Stock Advisor recommendations. The Fool has a disclosure policy.

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