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Highlight Copy & Paste Barron's 3/1/14: Lewis Braham
How's this for irony: In 2013, Bill Miller's Legg Mason Opportunity fund (ticker: LGOAX) delivered a chart-topping 68% return, yet his shareholders won't owe a dime in capital-gains taxes this April. Meanwhile, investors in the Royce Premier fund (RYPRX) will have to pay taxes on $2.27 per share of long-term capital gains, even though the fund lagged behind 95% of its peers.
Tax season is upon us, and it's time to rethink your assumptions about how to build a portfolio that keeps the IRS at bay. After a year in which stocks rose more than 30%, even laggards like the Royce fund—which returned 28% last year—have accumulated significant gains on their books. According to Morningstar, the average U.S. stock fund with more than $1 billion in assets now has a 23% potential capital-gains exposure. That means there are $230 million of taxable capital gains per every $1 billion invested in funds.
Minimizing taxable investment gains and income is more important than ever. Married couples with taxable income of more than $450,000 will see their long-term capital gains taxed at 20% this year, instead of 15%.
Those rates can be even higher thanks to two new taxes. First, there's an additional 0.9% Medicare surtax on married couples with earned income of more than $250,000. Since the tax on short-term capital gains and some dividend income is equal to investors' highest income tax rate—now as high as 39.6%—those investment gains could hit 40.5%. Second: Investors with more than $250,000 in adjusted gross income (for married couples) could pay an additional 3.8% in a special Medicare tax on some of their investment income. "The sticker shock for our clients will come this March when their tax bills arrive," says Jim Holtzman, a financial planner at Legend Financial Advisors in Pittsburgh. "They're going to be hit with about $5,000 to $7,000 more in taxes on average."
THERE ARE TWO WAYS TO MINIMIZE the taxes your funds generate. For many financial advisors, the solution is buying low-turnover index funds. Advisor John Smartt Jr. of Financial Counseling & Administration in Knoxville, Tenn., bought his first index fund, the Vanguard 500 (VFINX), in 1989 and hasn't looked back. Now he favors the Vanguard Total Stock Market Index ETF (VTI), which basically buys and holds every U.S. stock forever, so no gains are distributed.
Brace yourself for the second idea: Scour a fund's semi-annual report for losses they have on their books. Granted, "read the fine print" is tough advice to swallow, but the Internet makes it easier and potentially quite rewarding. Search for the words "loss" and "depreciation" in the Opportunity fund's latest report, for instance, and you'll find it has accumulated $1.9 billion worth on its balance sheet to neutralize future gains. These were generated during two brutal downturns in 2008 and 2011 during which Miller's reputation suffered. Now that Miller seems to have his groove back, the fund could be an interesting buy for the tax-averse. By contrast, Royce Premier had $2.5 billion of unrealized capital gains listed in its June 2013 report. So more distributions may be coming, even if it continues to lag behind its peers.
Finding funds with losses on their balance sheets can be tricky, though. Funds crushed in 2008 may have used up their losses. Also, the tax law then only allowed losses to be carried for seven years—so whatever losses remain will expire soon.
The good news is that in 2010 the tax law changed so that balance-sheet losses never expire. Funds in areas—such as gold—that have suffered losses since then have an advantage tax-wise. Vanguard Precious Metals and Mining (VGPMX) and Fidelity Select Gold (FSAGX), for example, each have more than $1 billion in losses on their balance sheets after last year's rout. (Subscribers to Morningstar can screen for funds with negative "potential cap gains exposure.")
Similarly, funds with emerging markets exposure that took a dive in 2011 and 2013 are also sitting on losses. The key here is to find funds that have strong long-term records and explainable recent hiccups. Case in point: the $4.3 billion Janus Overseas fund (JAOSX), which has $1.1 billion in accumulated losses. Over the last 10 years manager Brent Lynn's fund has delivered an 8.6% annualized return, compared with just 6.5% for its peers in its Morningstar category. But recent performance has been volatile and abysmal. Lynn's more aggressive style may shine as emerging markets recover, and the fund will be able to shelter its taxable gains.
Another tack: funds that have replaced a money-losing manager with someone with a strong track record elsewhere. "That's like investing in a completely different fund," says HLM Capital's Benjamin Leshem who seeks out such funds for clients of his financial planning practice in Deerfield, Ill. After lagging badly for many years, Columbia International Value (NIVLX) replaced its former subadvisor Brandes Investment Partners with an in-house Columbia manager, Fred Copper, last June. Copper's Columbia Overseas Value fund (COSZX) has beaten more than 80% of its peers in the last five years. Columbia International Value has $570 million in losses, $171 million of which have no expiration date, and just $277 million in assets. Its shareholders won't be paying any capital-gains taxes for a long time.
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