Capital gains distribution an unavoidable 'annoyance'


February 14, 1993|By WERNER RENBERG

When promoting their equity mutual funds, sponsors usually cite the funds' total returns and compare them with those of other funds or of a stock price index. If it's appropriate, they stress the funds' dividend records, too.

In a recent mailing piece for the Neuberger & Berman Guardian Fund, Chairman Stanley Egener added an unusual boast to such past performance data: an annual capital gains distribution. "Guardian Fund shareholders," he wrote, "have earned an income dividend every quarter, and a capital gains distribution every year, since 1950 when the Fund was established."

Since current income is an investment objective of the fund -- after capital appreciation -- Egener's plugging 42 years of quarterly dividends is understandable.

But distributions of long-term capital gains?

To many mutual fund shareholders, they're unwelcome payments. That's because they are subject to income tax, whether the distributions are reinvested in additional shares or taken in cash. Moreover, being unpredictable, they complicate individuals' tax planning.

Not all investors see capital gains distributions in the same light, however. Some look at them as just another type of cash payment that's taxed at the same rate as dividends. (Since 1987, that is; previously, long-term capital gains were taxed at lower rates.)

Welcome or not, capital gains distributions are an inherent aspect of mutual fund investing for at least three reasons:

* Portfolio managers frequently need to sell some of their funds'

stocks or bonds to implement their investment strategies -- such as when replacing richly priced securities with undervalued ones -- or to raise cash to meet shareholders' redemption requests.

* In most years, managers typically realize net capital gains because they are likely to sell more securities at a gain than at a loss. (When managers realize too many losses, they can be carried forward to offset gains in future years.)

* Federal tax law requires funds to distribute essentially all of their realized net gains (as well as their income) to their shareholders each year.

Some 70 percent of 1,007 general equity funds made capital gains distributions last year, while about 80 percent paid income dividends, according to Lipper Analytical Services. Capital gains distributions were most common among growth and income funds (74 percent), least common among small-company growth funds (63 percent).

The tax-exempt fund pattern was particularly noteworthy. Capital gains distributions were made, for example, by as many as 105 of 136 general municipal bond funds. Given that bond prices rose as interest rates fell, they could have been expected -- but they still surprised a number of investors.

Given the different reactions to capital gains distributions, are fund portfolio managers asked to maximize or minimize them?

As stock yields have slipped, managers of some funds have been under pressure to realize gains to maintain desired cash payout rates for shareholders, says Allen Goldstein, national director for investment company services at Price Waterhouse.

But executives at several fund complexes, treating distributions as a byproduct of investment decisions, assert that their managers need not consider them when deciding whether to sell or hold.

David B. Jones, director of operations development at Fidelity, emphasizes that it could be too risky to defer the realization of capital gains from one year to another to hold down distributions. "It's not going to do you any good to defer a gain," he explains, "if it's not a gain by the time you sell."


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