FIRST, YOUR mutual funds started losing your money. Next, they will start losing your losses.
This strange-sounding scenario will make today's bad situation even worse when shareholders begin to miss out on the one good thing they get by holding losers in a down market, namely tax benefits.
It's a complicated situation that has been almost completely ignored by the fund industry, politicians and the media, even though it fits perfectly with the current socio-political agenda of giving small investors a fair shake and increased tax benefits.
To see what's happening and why the rules should be changed, let's put on our hip waders and plod into the murky world of mutual fund taxation.
When a mutual fund realizes a loss, it can use that decline to offset its trading profits for the next eight years. By comparison, individuals can use a loss until it is exhausted, no matter how long that takes.
That schism between rules governing individuals and funds is the heart of the matter.
When things are going well, shareholders pay taxes on their fund's capital gains (assuming the fund is not held in a tax-advantaged account). That's because funds are "pass-through investments" and their tax burdens pass through the corporate entity directly to the owners. This is why so many fund investors footed big tax bills on their winners during the late 1990s bull market.
But when a fund goes into the dumper, that pass-through benefit stops. The losses stay with the fund, and the shareholder gets nothing. (If a fund's realized losses were passed to you, it would generate a tax deduction, effectively a "negative capital gain.") "Until now, this has never really been an issue because it hasn't come into play," says David Mangefrida, national director of asset management tax services for Ernst & Young in Washington. "But I believe everyone can agree that an individual investor does not deserve a worse result when they invest in a mutual fund than if they owned the individual stocks that make up that fund. Under the current rules, the fund investor suffers."
The issue is coming to the surface because so many funds have enormous losses, the kind that the manager has no realistic hope of offsetting with gains in the next few years. Consider that, according to Morningstar Inc., there are nine funds with losses that represent more than 10 times their current share price.
Red Oak Technology Select, for example, has realized losses - on stocks it has already sold - of $668 million, according to Morningstar. It has unrealized losses - on stocks it still holds - worth another $1.1 billion.
Combined, that's a potential capital loss exposure of more than 1,000 percent of the fund's current price.
To use that loss fully, the fund needs a 10-fold increase, and most of it will have to be within the next eight years. That would require an average annual gain of roughly 33.3 percent until about 2011.
No stinking way.
While that's an extreme case, huge losses hardly are rare. Among the many funds where the loss exposure is more than three times the current price, according to Morningstar, are Fidelity Aggressive Growth, Janus Enterprise, Putnam OTC Emerging Growth.
Funds have these inflated losses in part because investors gave up on ever seeing a turnaround. Because tax-loss carry forwards stay with the fund - instead of exiting with the shareholder - the potential benefits get spread among the smaller pool of remaining investors.
The more people who bail out, the bigger the potential tax benefit to the hangers-on. It would be an incentive to stick around, if only the loss carry-forwards didn't expire and investors could expect a tax-efficient rebound for years to come.
Furthermore, under current rules, big losing funds can't even use all of their losses if they go through a merger with a fund that has gains. Only a portion of the losses - as determined by a formula so complex it makes accountants queasy - can move along when a losing fund goes through a merger.
The government and the fund industry would give a lot of investors a break if it would push to end the time limitations on loss carry forwards. Until that happens - and don't hold your breath - investors who have stuck it out with losers have one more reason to cry, "Woe is me."
"It has never seemed fair to me that realized gains have to be distributed and realized losses stay with the fund," says hedge fund manager Jerry Paul of Quixote Capital in Greenwood Village, Colo. "Obviously, people thought that the stock market would move toward gains if you waited long enough. But now that it has become clear that so many funds will never be able to use all of their losses, something really should be changed."
Chuck Jaffe is senior columnist at CBS Marketwatch. He can be reached at firstname.lastname@example.org or Box 70, Cohasset, Mass. 02025-0070.