Guidelines for Capital Gains Tax

Guidelines for Capital Gains Tax:
Potential Tax Headaches for Small-Cap Investors
A Special Report for Dynamic Market Alert
by Todd Schoenberger
Editor, Diligent Investor and American Capitalist


It's always a good idea to frequently review your investment portfolio, but it's an even better idea to know what your potential tax liabilities are going to be when it comes to filing your return in the spring. Investors should always start early to avoid any tax pitfalls before the end of the calendar year.

One area of concern is with small-cap mutual funds. These funds do exactly what the title suggests: They invest in small market-capitalization stocks, usually holdings with a market cap of $300 million to $2 billion. These funds are sometimes considered a riskier investment than a fund that invests in a larger market cap asset class.

Capital Gains Taxes Hit Small-Cap Investors

Well, recently in The Wall Street Journal, editor Eleanor Laise discusses the tax "surprises" hitting investors with small-cap mutual funds. Eleanor's reason is a lot of small-cap fund managers are leaving their positions for other opportunities, like hedge funds, and leaving the door open for a new manager to liquidate some positions that the manager may not be in favor of. As a result, a capital gains tax is usually assessed to the shareholder if the investment is in a taxable account.

One example noted in the article is the Fidelity Magellan fund, which distributed an eye-popping $9.7 billion in capital gains this spring.

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This amount represented nearly one-fifth of the overall fund's new asset value. As the Journal notes: "Investors shouldn't confuse capital gains distributions with higher returns from their fund investments. However much a fund pays out to investors in capital gains, a like amount is subtracted from the fund's net asset value. The end result: Investors haven't gained anything from the distribution, but owe taxes anyway."

Guidelines for Capital Gains Tax: Trend Isn't Good for Small Caps

Unfortunately, the trend of small-cap fund managers probably isn't going to end anytime soon. As Morningstar, Inc. observed, the average mutual fund manager had been on the job for about 4.5 years, down from 5.3 years two years earlier. This trend is a sign that small-cap funds - and their stock components - are soon to fall out of favor for the more defensive asset classes, such as large-cap stocks.

As we have mentioned in previous issues of The Diligent Investor, small-cap investments suffer greatly when the FOMC is between rate cycles. And, we have suggested the prior Greenspan/Bernanke Fed rate cycle is over and an easing period will begin sometime in late first quarter of 2007.

Small Cap vs Large Cap: What’s in Favor?

When researching historic market activity, analysts quickly note the success of large-cap stocks, and the miserable performance of small caps, when we are in between these rate cycles.

As a result, a lot of small-cap fund managers know the good old days are probably behind them - and if they are going to make a move to a better opportunity, then the time is now.

If you are an investor in a small-cap mutual fund, ask the tough questions of how long is the tenure of the fund manager and gauge their performance. If the performance is suffering and the manager has been there for a handful of years, you may be on the edge of receiving a significant tax headache. So, it's best to be aware of it now so you can make preparations before tax season begins.

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Other Articles by Todd Schoenberger:
IPO Advantages and Disadvantages: Buy MasterCard IPO
Gas & Oil Mutual Funds: Lookin' for Oil in All the Wrong Places
Current Rate of Inflation in United States: Investors Tell the Fed to Take a Hike
Gas & Oil Mutual Funds: Where People with $14 Billion Put Their Money

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Copyright 2006, The Taipan Group, LLC and Dynamic Market Alert, 808 St. Paul St., Baltimore, MD 21201
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