Lipper Research Analyst Don Cassidy on WBIX AM-1060
Monday, October 18, 2004
Q. Don, here we are in the middle of October already -- and doesn't thatmean it is "tax season" for mutual funds?A. You're right: a large majority of mutual funds have adopted October 31(rather than December 31) as the close of their years for tax purposes.
Q. What does this mean to investors -- and in terms of how funds' actionsmight affect the markets?
A. A combination of the IRS code and the Investment Company Act of 1940requires that mutual funds pay out substantially all of their netinvestment income and their net realized gains each year. The measurementperiod that most funds choose is a year ending October 31, rather thanDecember 31.
Q. Why is that?
A. I think it is just that using the end of the calendar year would createtoo much of a time crunch. A lot of people on Wall Street take the finalweek or so off to be with family, and the market is a bit thin in the finaltrading days, and funds need to figure their distribution amounts and tradeEX those amounts by December 31, so if your books are still open at thattime it makes for a lot of tense action and possible errors. So October 31works a lot better, even if it IS also Halloween.
Q. OK, so how does the October 31 year-end affect how mutual funds may beacting in the markets over the next couple of weeks?
A. In a way, funds may very well think and act quite a bit like anindividual investor does. Individuals do not very much enjoy paying taxes.So in December there is a tendency to postpone taking gains and to naildown paper losses so as to reduce currently due taxes.
Q. And for funds?
A. Well, they mainly have an October 31 close, as we mentioned. Whilemutual funds themselves do not PAY taxes, they DO have certain incentivesto tidy up their books for the year because of how gains and losses affectinvestors, and media commentary.
Q. So, would they be selling their losers and holding or adding to theirwinners by the end of this month?
A. They MIGHT. There is a lot of media attention paid to the so-calledtax-efficiency of funds. We have that measure as one of our five keyscales in LipperLeaders.com, and my colleague Tom Roseen publishes a bigannual report on fund tax efficiency and costs. IF a fund has some losseson paper, it can take those losses and thereby reduce the amount of gainsdistributions it would otherwise need to pay out to holders inNov/December.
Q. And paying out less is GOOD?
A. Yes, since people must pay taxes on their funds' distributions -- andpeople do not like paying taxes if they can postpone or avoid them. Andnot paying out a lot makes a fund's tax-efficiency rating look better.
Q. So then, funds are likely to time some of their loss taking beforeOctober 31?
A. To some degree. We like to think that the portfolio manager's judgmentof investment and price prospects is the main issue, but that is nevercertain, and near-term tax savings can be made certain. But there isanother, more subtle incentive not to pay out: not all distributions getautomatically reinvested, and the fund company would like to keep assetsunder management.
Q. So, do you think this will be a big influence in the markets thisOctober?
A. It is hard to generalize and be accurate. This has not been a greatyear for equity (or bond) funds, so the "need" to harvest losses to offsetgains is probably smaller than in a better "up" year. But some funds aremore sensitive to this than others.
Q. Like what kinds of funds?
A. Well, any funds that hold themselves out as 'tax-managed' certainly paya lot of attention. And some types of funds will have good gains on thebooks this year while others may not. The stronger ones will beinternational stock and bond funds, real estate funds, clearly the naturalresources funds, maybe the gold funds, value as contrasted with growth,smaller-cap as contrasted with large, and so on.
Q. So is it likely that all those kinds of winning funds would be takinglosses, and depressing the market?
A. It would be focused on bad-acting stocks rather than across the board.Also, the winning types of 2004 do not happen to be the huge-asset areasheld by most investors. Growth and S&P 500 are, and they have not donemuch lately. And for three reasons, it appears to me that the effectshould be only moderate in late 2004...
Q. And what are those?
A. Well, first, one should remember that the mutual funds own only about16% or so of the stock market, so they are hardly the dominant force intrading. Second, 2004 has been frustrating but certainly not a broadprofit/loss disaster like 2001 or 2002. So it is not like there aremassive losses just waiting to be taken, OR huge profits across the boardthat "need" to be offset. And Third, remember that a lot of equity fundsstill have some loss carry-forwards from the bear market, so those wouldnot need to take further losses for tax reasons.
Q. Will different funds of the same general type (investment objective)tend to act the same way?
A. Clearly there will be some variation depending on individual positionsheld. But I think one major factor will be the age of the funds: The olderthe funds are, the more likely they have unused losses left over from2001-02 and thus they would have less "need"/incentive to nail down newlosses in 2004.
Q. How about the election effects, Don? If Senator Kerry wins, might wenot see removal of the low bracket on capital gains in 2005, pushingportfolio managers to nail down gains and losses this year?
A. I hesitate to make political predictions. But the polls I read say itis unlikely, barring some major upset before Nov 2, that the Republicanswill lose control of the House of Representatives. That would make passinga tax increase such as you described virtually impossible.
Q. Finally, we hear a lot of warnings to investors not to "buy adividend." Does this mean investors should hold off on buying funds untilafter Oct. 31?
A. Actually, no. The key date for that is NOT when the fund's chosen taxyear ends, but the date it trades "ex" its year-end distributions if any.That usually happens in December and in a few cases in November. Peopleshould check with the fund company 800 line or its website to get estimatesof the actual dates and amounts if any. But best to check AFTER October31 rather than sooner.
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Don Cassidy is a Senior Research Analyst at Lipper specializing in fund flows, exchange-traded funds, (ETFs), closed-end funds, equity fund performance, and author of Trading on Volume (McGraw-HIll).
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