Don't Get Caught

By Daniel Kadlec

One of the things I learned the hard way in college is never to accept the third turn with a pilfered fire extinguisher. You think you're going to get to blast an unsuspecting roommate, but you end up a two-time loser--inheriting an empty canister just as the campus cops show up. A similar fate awaits many mutual-fund investors this year. Redemptions from stock funds are running at the highest level in a decade, and those who stay put could wind up holding a big tax liability--essentially having been handed that spent fire extinguisher. Here's how it works. Mutual funds pay no income or capital-gains taxes so long as they pass on the gains and resulting tax liabilities to shareholders once a year, usually in November or December. Most investors never take a fund's distribution as cash; they reinvest it and pay the tax out of pocket. That's why the worst time to buy a stock fund is just before the annual payout. You get hit for a year's worth of taxes even if you owned the fund briefly.

For money held in tax-deferred accounts like a 401(k), this isn't a big deal. But more than half of all stock-fund assets are in taxable accounts, where the annual distribution is a long-standing sore point. Fund managers can minimize the hit by cutting down on trades, but with this year's heavy redemptions, even tax-conscious managers can't avoid a deadly double whammy.

Part 1 of the whammy: heavy redemptions often force a fund manager to sell stocks and book gains that would otherwise be avoided, just so they can pay departing investors. Part 2: fewer remain to share the tax liability.

On balance, investors continue to pump a lot of money into stock funds--$103 billion more than they took out through July. But last year that figure was $144 billion. And on the redemption side (ignoring new money coming in) the bloodletting has rarely been so extreme. At the current pace, investors will cash out $732 billion from stock funds this year, equal to 22% of the industry's $3.4 trillion in stock-fund assets. That percentage has run in the middle teens since 1990, according to the Investment Company Institute, a trade group. Why all the selling? Possibly online stock trading and Internet speculation--not to mention frustration with middling returns--are redirecting money away from stock funds.

What does it mean to you? Be especially careful what funds you buy for the rest of the year. High-flying (and often fast-trading) Internet funds are ripe for large taxable distributions. Take Amerindo Technology Fund, up 389% the past 12 months. It just sold most of its huge stake in Yahoo, and says that this year it will have its first distribution since inception. Wait before buying. But if you already own, don't sell to avoid the distribution. You'd realize a huge taxable gain on your fund shares.

Another flag is the aforementioned heavy redemptions. Take Oakmark Fund (which I own). After a brilliant run early this decade it has lagged badly the past two years. This year shareholders have withdrawn $2 billion more than they've put in, a drop equal to a third of the fund's assets, reports AMG Data. Manager Bob Sanborn has been forced to sell long-held stocks and realize the gain. "I'd be shocked if our distribution is not aberrationally high," he says. So don't buy now; it might even make sense to sell (I'm not) if your shares haven't gone up much. Other guideposts to a potential big hit: a new fund manager and excessive trading (a turnover rate above 100%). If you can help it, no point getting stuck with the evidence.

See time.com for more on funds. Dan is a guest on CNNfn Tuesdays at 12:45 p.m. E.T. and BNN radio Mondays at 5:40 p.m. E.T.