PRACTICAL STOCK INVESTING

don’t look in marketing materials

There are two ways for a mutual fund or ETF to have amassed large realized investment losses:

–they’ve had a very weak or very unlucky portfolio manager in charge of a fund, with the result that it has made losses in a benign investment environment, or

–the fund has simply existed during a period of great euphoria, when all the money flowed in, and a subsequent panic, when that money flowed back out at a loss.

The past several years have been such a period and have, by and large, produced the situation funds and ETFs are now in.

No one is going to advertise “Great news!!  We’ve lost billions since 2007, so you have a built-in tax shelter for future gains.  It’s so big your gains will be tax free for years.”

Quite the contrary.  A fund management company will provide this important information only when forced–that is to say, only in its official reports to shareholders and to the SEC.  You have to dig it out.

get the annual/semi-annual report

You can usually get the official reports on a fund company website.  You don’t want a summary report, or an abbreviated “fact sheet.”  That won’t have what you’re looking for.

Or you can go to the SEC’s EDGAR website.  Here’s the link.

On the Filings and Forms page, select the red “Search for Company Filings” link.  That will bring you to the search page.

Click on the red “company or fund name…” link.  That will bring you to an “Enter your search information” box, where you can enter either the fund name or its ticker symbol.  (This is the same search function you’d use for any publicly listed company.)

Clicking the “find companies” button will take you to a list of the fund’s SEC filings.

Look for the Certified Shareholder Report, form N-CSR, or semi-annual report, form N-CSRS.  That’s what you want.

inside the report

Go to the financial statements.  Note the date of the report, since all figures will be as of that date.

Statement of Assets and Liabilities

Find the “Statement of Assets and Liabilities.”

It will have three sections:  Assets, Liabilities and Net Assets.  Net Assets is the one you want.

There are two lines you should be interested in:

–”Accumulated undistributed net realized gain (loss) on investments and foreign exchange transactions.”  This is the figure you want! If it’s a loss, it will be in parentheses, like (2,345,678).  No parentheses if it’s a gain.

–”Net unrealized appreciation (depreciation) on investments and assets and liabilities in foreign currencies.”  This will show you whether the fund has an aggregate gain or loss stored up in the securities it still holds and has not yet sold.  This is a nice-to-know number, but it needs further refinement (see below).

schedules/tax footnote

There are two more pieces of information you should have.  There’s no standard place to find them, so you may have to do some poking around for yourself.  They are most likely either in a schedule immediately after the Statement of Assets and Liabilities or in a tax footnote.

The first item is when the tax losses expire.  This must be disclosed if it’s relevant, but need not be if it isn’t.  What I mean by relevant is, say, that the fund has unrealized gains of $250 million and accumulated losses of $2 billion that expire in December 2010.  In this case, the tax losses will likely expire unused.

The second is the gross unrealized gains and gross unrealized losses.  A fund may have $250 million in net unrealized gains, but that may be composed of $500 million in unrealized gains and $250 million in unrealized losses.  The gross unrealized gains show the real ability of the fund to generate gains that will use up the realized losses.

how to use this information

The first, and obvious, comment is that the foremost criteria for selecting a fund are its suitability for you, given your goals, risk tolerance and financial situation.  Tax benefits are nice to have, but they’re a second- or third-order consideration.  Better to have a fund run by a skilled manager inside a firm with strong dedication to good performance, with no tax losses, than one with tons of tax benefits but a weak manager and a deficient corporate culture.

In most cases, the losses funds have today have been caused by the market action of the past few years.  It’s possible, though, that in some cases losses have been generated by bad management (I know. I’ve been hired more than once to clean up a mess someone else has made).  These turnaround situations can have, I think, great profit potential.  But with so many funds with strong management being in a loss position that has significant value, I see no reason to take the extra risk.

A fund example: I was looking at a mutual fund the other day as I was preparing for these posts that had roughly the following characteristics:

Assets:  $2 billion

Accumulated realized losses:  ($1.8 billion)

Unrealized net gains:  $700 million, consisting of $1 billion in gross unrealized gains and $300 million in gross unrealized losses.

A rough calculation of the value of these losses:

Assuming a federal tax rate of 15% on capital gains and (in my case) a state tax of 10%, the ability of (my share of) $1.8 billion in losses to shelter realized gains from being distributed to me as taxable income would be worth (my share of) $1.8 billion x .25 = (my share of) $450 million, or 22.5% of (my share of) the net assets of the fund.  That’s a lot.

This raises two other points:  don’t forget to include state taxes in your calculation; at this point it looks as if capital gains taxes will be going up for individuals with more than $250,000 in yearly income.  That would make a fund like I describe more valuable to the wealthy.

what can go wrong?

The worst problems would come from selecting a fund with poor management.  Let’s exclude this issue.  There are still potential pitfalls.

1.  The stock market stays in the doldrums.  As a result, it remains difficult for any manager to make gains to use up the tax losses before they expire.

2.  The fund manager doesn’t “get” the value of the tax losses.  Normally a manager sensitive to tax efficiency tries to avoid short-term trading.  When you have a big loss position, a somewhat greater trading orientation–provided you have the temperament and skills–is appropriate.

3.  Investors pour tons of new money into the fund you select, either because they realize the value of the tax losses or for some other reason.  The issue is this:  in the example above, the net assets of the fund are $2 billion.  If I put even $1 million into the fund, that represents only .05% of the fund assets, so portion of the tax losses that existing shareholders are entitled to is basically unchanged.  But if another $2 billion in new money comes in, then the entitlement of each existing share is cut in half.

How likely is this “unfavorable” outcome?  It’s hard to tell.  In my experience, only one thing will attract new shareholders–sharp price gains.  But that will also trigger outflows from existing shareholders who have decided to hold on to underwater shares until they’re back at breakeven.

4.  Your fund is merged into another one.  Fund companies will many times merge funds that are perceived to have weak records, or which can’t seem to attract new money, into other “healthier” funds.  The rules on what happens to tax losses in this case are complex, but the basic idea is that the ability of the successor fund to use the losses is severely restricted.  So not only do you have to share the losses with the holders of the other fund, but their present value is diminished.  It’s of course possible that the fund you’re merged into will have a bigger tax loss position that yours, but I wouldn’t count on it.

As a practical matter, I think #4 is the biggest risk.  Fund boards may have no understanding of the value of the tax losses.  And they generally tend to go along with the wishes of the fund management company.

On the other hand, if you have a choice between two roughly equivalent funds, one with large realized tax losses and one without them, I think the decision is a no-brainer.