Don't assume a conspiracy when fund disappoints you

Your Funds

Dollars & Sense

July 14, 2002|By CHARLES JAFFE

WITH NEW accounting scandals arising almost every day, it's easy to be a bit paranoid about investing.

But mix fear with a less-than-complete understanding of how mutual funds work and you have a recipe for disaster.

As an illustration, listen to the tale of James M. of Sacramento, Calif., a reader who sent me a letter stating that he was wronged by a fund company but who, on closer examination, perpetrated a crime unto himself by mismanaging an investment.

It's a cautionary tale at a time when it seems as if the entire investing community is out to get the individual investor.

James - he did not return phone calls, so I'm not revealing his last name - invested in American Century Ultra (which confirmed that he was a shareholder). He claimed that his tax returns were "screwed up" each year by having to account for the fund's annual capital gains and dividends distributions.

When James had received no tax paperwork from the company by the middle of March last year, he was concerned. He called American Century and was told "there were NO dividends or capital gains for 2001!" according to his letter.

James was surprised because Ultra owns companies "like Philip Morris which always pays dividends." So he called American Century and was told that the firm had used losses realized on some investments to offset the profits it made on others. The losses wiped out the gains, so the company made no distribution last year.

James wrote that this was "Enron-type accounting! ... It might be legal but it was not ethical or moral!"

He grew even more concerned after getting his first-quarter statement, fearing that American Century had miscalculated the cost-basis for his investments.

Cost basis is the amount an investor pays for shares. It is used to determine profits or losses when a fund is sold.

In James' case, he was surprised to learn that his cost basis was "greater than the present value of my account!" (This obviously excited him, but that's the hallmark of a loss. Ultra, a long-term winner, has had losses during the past two years.) "It's obvious," James' letter concludes, "that American Century is very dishonest and manifests an ongoing criminal behavior and deserves to be prosecuted." He then impugned the company's accounting abilities, before noting that he was "so disgusted with all of this that I cashed out, rather than wait until my account went down to zero."

American Century spokesman Chris Doyle says, "The bad market has made people more paranoid and skeptical. They have learned that chief executives are scam artists and accountants are con men. The result is that the most innocent thing you do can be interpreted as underhanded."

American Century investors can rest easy. Nothing untoward is happening here. But James' sell-off highlights how a lack of knowledge about funds can hurt you.

Mutual funds are "pass-through" instruments, meaning that whatever tax consequences the fund rings up through buying and selling stocks get passed through to the shareholder. Just as individual investors can wipe out gains from one stock with losses from another, so can a mutual fund. If losses offset all gains, a fund pays no distribution and investors get no tax paperwork.

Because distributions are taxable - unless the fund is in a tax-advantaged account - not having a payout is good news. James, who was miffed that gains messed up his tax return, should have had an easy time filing his papers last year.

Offsetting gains with losses isn't unethical or immoral; it's smart tax management. If James had a loss in Ultra, he should use it to offset any gains.

And if James miscalculated his cost basis - which is probable given his confusion over fund tax calculations - he is likely to understate any loss or overstate any profit. Either way, that means overpaying taxes.

Scandals might be rocking the financial industry, but don't jump into conspiracy theories the first time something strikes you as peculiar.

Educate yourself first.

Start with the fund's explanation. If that seems odd, ask for documentation, an account history or a rules citation that backs up the numbers you're questioning.

If it still doesn't make sense, contact the proper authorities. The Securities and Exchange Commission (www.sec.gov) can not only help answer these types of questions, it can process complaints against fund companies.

But recognize that the fund business has been around for more than 75 years largely without the huge scandals that have rocked individual stocks recently.

It's natural to be nervous about all investments in this environment, but it's foolhardy to assume the worst without a proper understanding of how funds work.

Chuck Jaffe is mutual funds columnist at The Boston Globe. He can be reached by e-mail at jaffe@globe.com or at The Boston Globe, Box 2378, Boston, Mass. 02107-2378.

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