Overlooking This Detail Can Cost You (Dearly)

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

And while stock mutual funds have been bruised and battered this year, funds still make a lot of sense.

Convenience is king
For one thing, they're convenient. Funds leave the stock-picking to paid professionals, while providing instant diversification. Take the Vanguard Capital Opportunity (VHCOX) fund, for example. Owners of this now-closed fund are exposed to growth stocks both large and small, across many sectors. For example, Research In Motion (Nasdaq: RIMM  ) , FedEx (NYSE: FDX  ) , Medtronic (NYSE: MDT  ) , Google (Nasdaq: GOOG  ) , Bed Bath & Beyond (Nasdaq: BBBY  ) , Monsanto (NYSE: MON  ) , and FormFactor (Nasdaq: FORM  ) are all among the fund's top 25 holdings.

Manager Theo Kolokotrones has an impressive track record -- he's worked in investment management since 1970, and has managed this particular fund since 1998. The fund boasts a "high" rating from Morningstar for its five-year, 10-year, and overall returns; however, not surprisingly given the overall market plunge, Vanguard Capital Opportunity has nosedived this year and is currently down a painful 40%.

It gets worse, though
But some investors sitting on those 40%-plus losses will also face capital gains taxes.

How, exactly, can a fund lose close to half its value and still stick you with a tax bill? It's that wily 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 you hold your fund in a taxable account (i.e., outside a 401(k) or IRA), you'll owe Uncle Sam if the fund manager sells investments at a profit.

And selling at a profit was possible this year, even with a 40% loss. This year's capital gains distributions have been caused largely by investors leaving stock funds, which forced fund mangers to unload appreciated stock to cover redemptions. According to TrimTabs Investment Research, there was a total of $204 billion in net outflows from all stock funds through October.

In fact, MarketWatch recently reported that this will be the first year since 2000-2002 in which investors will see both negative returns and capital gains. Our example fund, Vanguard Capital Opportunity, is down 40% year-to-date and has declared a capital gains distribution of $2.06 (or 10% of the fund's current net asset value).

While this is a double whammy, it won't put anyone into penury. According to MarketWatch:

The cost facing investors of funds' capital-gains distributions isn't as great as it may seem at first glance. The tax you pay now will either reduce the tax you owe when you sell your fund shares at a gain or increase your loss for tax purposes. Still, paying taxes sooner rather than later is the opposite of what you should be striving for, and robs a portfolio of the benefits of compound interest.

Some funds, too, have been creative in avoiding tax bills for their investors. Eric Bjorgen, co-manager of Leuthold Core, told the Belleville News-Democrat that his fund offset gains from its top-performing stocks by selling some of its losers and "finding similar stocks to buy." The aim, he said, was to cushion a bad year performance-wise by "neutraliz[ing] our capital gains to bring them down to zero so we didn't shock investors."

On-the-ball investors, listen up
There's a simple takeaway here: Although investors have no control over capital gains, you should never overlook tax implications before entering or exiting a fund. According to Money magazine, research has shown that the single biggest drag on fund returns is taxes (the average fund loses nearly two percentage points each year to taxes).

So, then, what should you do? Consider the following (especially near the end of the year):

  1. Be very cautious when buying funds in November and December, because you could immediately receive taxable income without having been in the fund long enough to see the gains that brought those taxes.
  2. Remember that capital gains taxes only affect investments held in taxable accounts -- not 401(k)s or IRAs. Consider your asset location when purchasing new funds (so, for instance, it might be more beneficial to put funds that trade frequently in tax-deferred retirement accounts).
  3. Look on the bright side. In an article in this month's Money magazine, finance professor Bill Reichenstein said, "Nearly every stock fund will have a built-in reserve of capital losses, which will cushion future gains for several years."

Reichenstein gave further reason for optimism: "At these prices you can buy stocks for next to nothing -- it's the only free lunch I have seen in finance."

And while you're at it, consider reevaluating your portfolio to get ready for the New 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 balance and 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. Because taxes can be such a hindrance to better returns, make sure your tax hit won't be too significant if you decide to invest -- or pull out of -- a stock fund. (You can check a fund's capital gains distribution schedule and amount by calling the fund company or going to its website.)

Avoiding unnecessary taxes, reevaluating your portfolio each year, and finding superior mutual funds for your long-term dollars are just a few of the Foolish tips covered in Motley Fool Champion Funds, the Fool's investment service dedicated to beating the market with funds.

If you'd like to get a jump-start on finding funds that are well-positioned for 2009, 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. FedEx is a Stock Advisor recommendation. Google is a Rule Breakers recommendation. Bed Bath & Beyond is an Inside Value and Stock Advisor recommendation. FormFactor is a Hidden Gems recommendation. Leuthold Core is a Champion Funds recommendation. The Fool owns shares of Bed Bath & Beyond. The Fool has a disclosure policy.


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