Watch Out for Distributions

It's particularly important for taxable investors to check out the capital gains pictures at the funds that are on their shopping lists this fall. Most domestic-equity funds have posted solid returns this year and strong gains over the past few years, while the vast majority of international-stock funds have earned excellent gains this year and impressive returns over the past few years. Thus, many of the former are sitting on a significant amount of potential capital gains exposure, and most of the latter are sitting on a substantial amount of potential capital gains exposure.

Potential capital gains exposure is our estimate of how much a fund would distribute to investors if it sold all its holdings. Funds normally distribute less than that amount. Higher-turnover funds generally dispense bigger portions of their gains than lower-turnover funds generally do. And asset flows also affect distributions: Major inflows tends to dilute distributions, whereas marked outflows do the opposite.

Here's a summary of the potential tax liabilities of the various domestic-equity and international-stock categories.

The Diversified Domestic-Equity Categories
Many blue-chip funds have a significant amount of capital gains to distribute. The median potential capital gains exposures for the three large-cap categories range from 14% to 21%, with the large-growth group at the low end and the large-value category at the top end of that spectrum. A number of prominent blue-chip funds have much bigger potential tax liabilities, including some high-turnover offerings such as Hartford Growth Opportunities (NASDAQ: - ) as well as several low-turnover funds like Tweedy, Browne Value (NASDAQ: - ) and Legg Mason Value (NASDAQ: - ).

The story is similar in the six small- and mid-cap categories. The median potential capital gains exposures for the small- and mid-cap categories range from 15% for the small-value group to 21% for the mid-blend category. American Century Vista (NASDAQ: - ) and a number of other good smaller-cap vehicles with high turnover have considerably more potential capital gains exposure than that, as do T. Rowe Price New Horizons (NASDAQ: - ), Royce Total Return (NASDAQ: - ), and several other attractive smaller-cap funds with low turnover.

The Specialized Domestic-Equity Categories
Sector funds are a mixed bag when it comes to their potential tax liabilities. Not surprisingly, given the huge declines they experienced between early 2000 and late 2002--and the big losses they were able to book and carry forward to offset future gains--the technology category has a median potential capital gains exposure that's negative and the communication category has one that's barely positive despite posting pretty strong returns in recent years. On the flipside, many funds in the health, financials, and real estate groups have significant potential tax liabilities. And the utilities, natural-resources, and precious-metals categories, which have been superior performers in recent years, have median potential capital gains exposure of 25% to 35%.

The Diversified International-Stock Categories
Partly due to the strength of overseas markets in recent years and partly due to the weakness of the U.S. dollar, foreign large-growth, foreign large-blend, foreign large-value, and world-stock funds have somewhat bigger potential tax liabilities than domestic large-cap offerings. Meanwhile, many of the most popular and successful foreign large-cap and world-stock funds have potential capital gains exposures that exceed their category medians of 22% to 26% by sizable margins, including Artisan International (NASDAQ: - ), American Funds EuroPacific Growth (NASDAQ: - ), Templeton Foreign (NASDAQ: - ), and MFS Global Equity (NASDAQ: - ).

Lots of potential tax liability is one side effect of the long and strong rally that foreign smaller-cap funds have enjoyed. Foreign small/mid-growth funds have a median potential capital gains exposure of 30%, in fact, whereas foreign small/mid-value offerings have a median potential capital gains exposure of 31%. And although there are a couple of pretty good foreign small/mid-cap funds that have somewhat smaller potential capital gains exposures and that are still open to new investors, namely Forward International Small Companies (NASDAQ: - ) and Putnam International Capital Opportunities (NASDAQ: - ), both of these offerings carry considerable tax risk in absolute terms and thus could well make significant distributions later this year.

The Supplemental International-Stock Categories
Except for the perennially disappointing Japan category, which has a negative median potential capital gains exposure, all of the supplemental international-stock categories have substantial potential tax liabilities. The diversified Pacific/Asia and the Europe groups have almost as much potential tax liability as the foreign small/mid-cap categories. Moreover, thanks to their extended and exceptional surge in recent years, the diversified emerging markets, Pacific/Asia ex-Japan, and Latin American categories have median potential capital gains exposures of 38% to 45%. And figures that high are an indication that nearly every emerging-markets offerings is carrying quite a bit of tax risk at present.

Conclusion
Of course, not every fund with sizable or even substantial potential capital gains exposure is going to make a significant distribution this year. But quite a few will, including a number of funds with low to moderate turnover rates as well as many with higher turnover rates. Indeed, Southeastern Asset Management recently estimated that Longleaf Partners Small-Cap (NASDAQ: - ) and Longleaf Partners International (NASDAQ: - ), which are lower-turnover offerings, will make distributions later this year that are equal to nearly 10% of their current NAVs. And Litman/Gregory recently estimated that Masters' Select Smaller Companies (NASDAQ: - ) and Masters' Select International (NASDAQ: - ), which have rather average turnover rates, will make distributions later this year that are equal to roughly 10% and 15% of their current NAVs, respectively. Thus, it's clear that investors who are looking to add equity exposure to their taxable accounts would be wise to wait until it's clear that the funds on their shopping lists aren't going to dispense distributions or until after the distribution dates for their prospective purchases have passed.

William Samuel Rocco has a position in the following securities mentioned above: ARTIX