Seven Mutual Fund Traps

1. LOSING PATIENCE WITH GOOD MANAGERS

Just about every mutual fund will eventually experience a slump in performance. It's tempting to jettison a lagging fund in favor of one with a head of steam, but a study by Dalbar, Inc., a research provider to the financial services industry, shows this could be a costly mistake. Dalbar found that from 1984 through the end of 1998, the average stock fund gained 12.8% per year. On the other hand, stock fund investors whose average holding period was less than three years earned an average of only 7.25% per year. Warren Buffett's company, Berkshire Hathaway, exemplified this finding. In 1973 it lost 11.3% while the Dow Jones Industrial Average (DJIA) lost 16.6%. In 1974 it lost 43.7% while the Dow lost 27.6%. In 1975 it lost 5.0%, but this time the DJIA gained 38.3%. By the end of 1975, many people had had enough and jumped ship. Those who stayed on were rewarded with a 147.3% gain in 1976. From 1973 through the end of 1998, Warren Buffett has provided Berkshire Hathaway investors with a 29.8% average annual rate of return. Those who thought the master had lost his touch in 1975 learned an expensive lesson.

Solution: Before selling a fund, ask yourself if it's lagging only because its style of investing is out of favor. Does it focus on small companies versus large? Does it look for rapidly growing companies versus undervalued, oversold companies? If the same previously successful manager is still running the fund, without a change in strategy, think of Warren Buffett before you sell.

2. BASING YOUR PURCHASE PRICE OR SELLING PRICE ON WHEN YOU PLACE YOUR ORDER

When you buy or sell a mutual fund, its share price is determined by the value of the stocks in the portfolio at the close of each trading day. Consequently, if you put in an order to buy at noon because the market is down, your purchase price will be considerably higher than expected if the market turns around and closes higher.

Picture this: You turn on the news and the top story is that the DJIA is down 500 points. This is the opportunity you have been waiting for. You quickly place an order to buy your favorite mutual fund. However, by the end of the day, the market makes a miraculous comeback, and actually closes higher. Your great buying opportunity slipped away because at the close the price of the mutual fund was not as low as you would have liked it to be.

Solution: Consider using exchange traded funds (ETFs). They track the performance of a specific index, but trade on an exchange just like stocks. Therefore, if the DJIA is down 500 points during the day, you can be sure to take advantage of this weakness by placing a real-time order to buy "diamonds" (DIA), an ETF designed to closely match the performance of the DJIA. There are other ETFs available for broad-based indexes such as the Standard & Poor's 500, various sectors, and international indexes. ETFs are similar to mutual funds, except they fluctuate during the trading day just like stock prices.

3. IGNORING DIVIDEND AND CAPITAL DISTRIBUTIONS

Each year, all mutual funds are required to pass on their interest, dividends, and capital gains from the sale of stock to their shareholders. Thus, if you purchase a fund in December, and it makes its dividend and capital gains distribution before year-end, you will be required to pay tax on the full distribution, even if the fund has decreased in value since you purchased it. As a real-life example, the Janus Fund distributed $4.39 per share on December 15, 2000. If you purchased 1,000 shares on December 1, you would have additional taxable income of $4,390. Even at the favorable capital gains rate of 20%, that would add $878 to your tax bill.

Solution: Ask the fund company for the record date of the next distribution. Make your purchase after that date, unless there is a compelling reason to buy beforehand. You could also invest in funds in your IRA, since they are not subject to taxes on distributions.

4. INCORRECTLY COMPUTING GAINS OR LOSSES

Most people reinvest dividend and capital gains distributions, thus receiving additional shares instead of cash. It's important to keep track of all distributions, because they are added to your cost basis when you sell. That's a fancy way of saying the total of all the distributions will lower your gain or increase your loss.

Here's how it works: Suppose you purchased a mutual fund five years ago for $10,000. Every year it made capital gains distributions in the amount of $1,000 for a total of $5,000. Further, all distributions were reinvested in the form of additional shares. If you sell the fund for $12,000, you have a loss of $3,000. The $10,000 purchase price, plus the $5,000 total capital gains distributions, equals a cost basis of $15,000. Subtract the $12,000 proceeds from the sale, and you have a loss of $3,000. If you don't think it's important to keep an eye on fund distributions, consider this: The Liberty Fund reported that during 1999, investors paid $42.68 billion in taxes on $187.6 billion in taxable mutual fund distributions.

Solution: Ask your broker or mutual fund company if they keep track of your cost basis. If not, it's up to you to do the recordkeeping. Make sure to ask your accountant if the gain or loss includes all reinvested dividend and capital gains distributions.

5. PURCHASING "B" SHARES INSTEAD OF "A" SHARES

Many people balk at the thought of paying a hefty 5.75% load (commission) up front. To assuage investors, mutual fund companies created "A" shares and "B" shares. The "A" shares carry a load up front, while the "B" shares have a deferred load, payable only if you cash out, usually before seven years. On the surface, the"B" shares sound like a better deal. After all, as long as you stay in the fund seven years or more, the load disappears. There's a trap: The "B" shares have substantially higher management fees than the "A" shares.

Let's look at an actual fund. The "B" shares for the Fidelity Advisor Balanced Fund have annual expenses of 1.7%. The "A" shares have annual expenses of 0.91%. That's a difference of 0.81% per year. If you hold the"B" shares long enough, you will eventually wind up paying more than if you just paid the 5.75% load with the "A" shares.

Solution: Compare the annual expenses for each class share, or purchase no-load funds, which have just one class of shares.

6. THE WASH-SALE RULE

With the tremendous decline in the technology sector, you may have funds with substantial losses. Selling a fund in order to claim a loss for tax purposes, and immediately buying it back so as not to lose your position in the fund, may sound tempting. Unfortunately, it's not as good as it sounds.

The IRS has something called the "wash-sale rule," which states that if you buy back the same stock or mutual fund within 30 days of selling it, the loss on the sale is disregarded. If you think that's harsh, there's more. If you first buy a stock or mutual fund that you already own, thereby doubling your position, and sell within 30 days, the loss will also be disregarded. For example, say you own 100 shares of the XYZ fund, and on June 1, you purchase another 100 shares. If you sell 100 shares before July 2, your loss will be disallowed, once again due to the wash-sale rule.

Solution: If you want to do some tax-loss selling, buy back a similar mutual fund. This way you will gain the benefits if that segment of the market goes up, and still be able to claim your losses.

7. USING A METHOD TO IDENTIFY SHARES SOLD THAT BENEFITS THE IRS INSTEAD OF YOU

The IRS allows you to figure the gain or loss on the sale of mutual fund shares by using one of four methods, each of which has its own benefits and drawbacks.

First in, first out (FIFO): This method normally benefits the IRS. It assumes that shares sold were the first shares you purchased. While fairly easy to understand, this method often leads to the largest capital gains, because the longer you hold shares, the more time they have to rise in value. If you do not specify a method for calculating your cost basis, the IRS assumes that you use the FIFO approach.

Average cost (single category): This method considers the cost basis of your mutual fund investment to be the average purchase price of all the shares you own, a figure that changes as you continue investing in a fund. Most mutual fund companies use this method to calculate average cost. Keep in mind that if you transfer mutual fund shares from one broker to another, the cost basis information could be lost. There are still mutual fund companies out there that don't provide cost basis information. Once you begin using an average cost method for the sale of shares of a particular fund, the IRS prohibits a switch to another method without prior approval. However, you may employ different methods for different funds.

Let's say you started out with 1,000 shares of XYZ Fund, purchased for $10 each. Later, you bought 1,000 more shares at $14 each. In the meantime, your dividends have been reinvested, and you get a notice that you received 100 shares, purchased at $12 each. With the single category method, you average them as in Figure 1. You can see why the IRS uses the FIFO method unless you specify otherwise. The taxable gain is $2,000 more using the FIFO method. In determining whether a sale generated a short-term or long-term gain, the shares sold are considered to be the shares acquired first.

Figure 1: Average cost vs. FIFO. If you use the FIFO method, your taxable gains are $2,000 more.

AVERAGE COST (DOUBLE CATEGORY): This approach is similar to the single category method, except you must separate your shares into two categories — shares held for a year or less (short term) and shares held for more than a year (long term). If you use this method, you simply use the cost basis that corresponds to the holding period of the shares you're selling. The advantage? You get to choose whether the shares are sold from the long-term or the short-term group.

SPECIFIC IDENTIFICATION: This method provides the most flexibility and therefore the best opportunity to minimize taxable gains. The first step is to identify the specific shares you want to sell. In most cases, these would be the shares bought at the highest price, so that you can minimize your gain. To use the specific identification method, notify your mutual fund company in writing and provide detailed instructions about which shares you are selling each time you sell or exchange shares. The mutual fund company or brokerage firm needs to provide you with a written confirmation of the specific shares sold.

Solution: Calculate the gain or loss for each method available. Pick the method most advantageous for your situation. If you have an accountant prepare your taxes, ask him or her which method is used, and why.

CONCLUSION

Being aware of these pitfalls can help you keep more of the money you earn in your mutual funds. A little extra planning today can make a big difference in building up your nest egg.

Peter Salzman is a certified public accountant who specializes in individual income taxes and financial planning. He can be reached at sal136@yahoo.com.

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