Mutual funds that make capital gains distributions after selling appreciated securities have long been criticized for passing the tax burden to investors. Shareholders take the hit even if they recently purchased shares and the gains came from prior years. Adding insult to injury, they also can get socked even if their fund loses money.

These days, the words "tax-efficient mutual fund" need not be an oxymoron. With a bear market well into its third year, many fund managers have an embarrassing cornucopia of losses that they can use to offset capital gains, often for years to come. And those losses are helping to ease the tax bite for shareholders in taxable accounts, as fund managers continue to liquidate their holdings to meet redemptions.

Last year, mutual funds distributed a scant $69 billion in capital gains, and market watchers say this year the figure almost certainly will be lower. Most mutual funds will make no capital gains distributions in November or December, and those that do will probably pay out far less than they did in previous years, they say. That means the age-old advice not to buy funds in the fourth quarter to avoid getting socked with capital gains tax liability won't apply to most funds in 2002.

A tax break is cold comfort to investors enduring a ferocious, multi-year bear market, but there is a silver lining. Mutual funds can carry forward their net capital losses for eight years. So when a turnaround comes, many funds will be able to chalk up years of healthy returns before they distribute a single penny of capital gains to shareholders.

"Fund managers did a lot of buying in late 1999 and early 2000, when cash inflows were particularly strong," says Rande Spiegelman, vice president of the Schwab Center for Investment Research. "The cost basis of the shares purchased during that time is pretty high, so many of them are sitting on substantial losses."

This is not an isolated phenomenon or one affecting just a few funds. Morningstar has an interesting but little-known statistic called "potential capital gains exposure," or PCGE, in its reports. The number reflects the percentage of a portfolio's assets that would be subject to capital gains tax if it were liquidated at a particular point. It includes realized gains and losses on securities that have been sold, as well as unrealized appreciation or depreciation on assets that remain in the portfolio.

These days, many funds have a negative potential capital gains exposure, which means they may be sitting on a tax-loss carryforward they could use to offset gains. If a fund had a PCGE of, say, -30%, its net asset value would have to rise at least that much at the time the calculation was made before shareholders would have to worry about capital gains distributions.

Funds have lost so much on their investments that the average potential capital gains exposure is negative for every Morningstar equity fund category except specialty-financial. Even that lonely group has a potential capital gain exposure of just 8%, which reflects the percentage of total assets with appreciation that has not been distributed to shareholders.

The average PCGE for the rest of the fund categories varies substantially. At -302%, the specialty-technology group has the dubious distinction of having the lowest possible exposure to capital gains taxes. (A PCGE can exceed 100% because the figure includes both realized losses from the sale of securities as well as unrealized losses from stocks still in the portfolio.) Asset classes with small negative average PCGEs include specialty-real estate (-3%), small value (4%), and mid-cap value (-5%). Rounding out the middle are categories such as European stocks (-48%), large growth (-73%) and large blend (-26%).

Planning Opportunities

Using a fund's PCGE as a benchmark for future tax efficiency is not foolproof. For one thing, the number can change substantially in a matter of weeks because of market fluctuation, inflows and portfolio shifts, so it's a good idea to call the fund to get the latest statistics. And a fund with the highest tax-loss carryforward will not necessarily be the most tax efficient. Fund portfolios with smaller losses, or even capital gains exposure, may be more tax friendly than those with hefty loss carryforwards if they have substantially lower turnover. Dividends can also skew the picture.

Perhaps the most important caveat is not to let the tax tail wag the investment dog. Some mutual funds with a large stash of tax losses are well managed and worthy of consideration. But others are volatile, fad-driven sector funds that got caught with lots of hot money just before the market downdraft or are simply poorly managed.

Although no one would suggest buying a fund dog to get potential tax goodies, some financial advisors are weighing tax-loss carryforwards more heavily in their decisions than they did a couple of years ago. "In a situation where there are two funds with similar investment objectives that you really like, the fact that one is in a better position to shelter gains in the future might sway your decision," says Spiegelman.

The average investor probably is not aware that many funds may not distribute capital gains for years, and mutual funds are not likely to trumpet the fact. Doing so would create the marketing nightmare of pointing out all of the lumps they have taken in the last few years that created those juicy tax losses.

But some financial advisors are not keeping the news a secret and are using the opportunity to help craft more tax-efficient portfolios for their clients. "Many people are aware of the tax issues that mutual funds had in the past," says Mark Johannessen, an advisor with Sullivan, Bruyette, Speros & Blayney in McLean, Va. "Explaining how buying into someone else's loss can work to their advantage helps alleviate those concerns."

Funds with large tax-loss carryforwards can be useful when clients need to sell their holdings to recognize their own portfolio losses. "We usually have two or three funds in our stable that have a similar investment style," says Johannessen. "If we sell a fund to recognize a tax loss for a client, we might replace it with a similar fund we like that has a larger loss carryforward."

Johannessen's says that some funds considered tax inefficient in the past now might have sufficient loss carryforwards to shed that label. "A fund that we would only have used for an IRA a couple of years ago may be a good candidate for a taxable account now," he says.

Mutual Funds Vs. Separate Accounts

In 2000, a lot of investors who had never considered capital gains distributions before got a rude awakening. Despite the fact that many mutual funds had plunged in value, they nonetheless produced crushing capital gains distributions. Forced to sell securities to meet massive shareholder redemptions, fund managers found themselves in the unenviable position of passing a record-breaking $326 billion in capital gains to shareholders whose portfolios were sinking. Many funds couldn't offset those gains with losses because the bear market was still young and they didn't have enough underwater positions.

Sponsors of separate accounts took the opportunity presented by the debacle to point out that they did not make investors pay for so-called "phantom" gains they never enjoyed. Some media reports even predicted that disillusionment by investors would lead to the eventual demise of the mutual fund industry.

But the fact that many mutual funds will see little or no capital gains distributions for years to come is not likely to lessen demand for separate accounts, says Avi Nachmany, director of research at Strategic Insight, a mutual fund research firm in New York. "Over the last few years, there has been a lot of exaggerated hype about the tax advantages separate accounts have over mutual funds," he says. "Now that this perceived advantage has gone out the window, companies that market separate accounts will likely promote benefits that are not related to tax issues."

Steven B. Enright, president of Enright, Mollin, Cascio & Ramusevic in Old Tappan, N.J. and Elmhurst, N.Y., says the potential benefit of larger fund tax-loss carryforwards has had little impact on his use of separate accounts. "From our experience, funds with large unrealized losses won't necessarily be more tax efficient because the manager may sell his winners to meet redemptions," he says. "Beyond that is the issue of cost. I just did a proposal for a pension plan with $7 million in assets that were invested in insurance company mutual funds. If I put them into a separate account with Schwab, I can cut their expenses by one-third."

Others say the promise of greater tax efficiency gives them all the more reason to stay in the mutual fund camp. "If someone has $100,000, and the choice is between five large-company growth stocks or one mutual fund that invests in 100 of them, a mutual fund with greater diversity and a proven manager is clearly the better option," Johannessen says. "The fact that the fund probably won't distribute capital gains for years because it has a large loss carryforward is icing on the cake."