(PUB) Morningstar FundInvestor

July 2 014

Morningstar FundInvestor

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Watch Out for the Tax Bill on These Funds Red Flags | Laura Lallos

extraordinary outflows of $1 . 4 billion over the past 12 months, more than its current total asset base of $1 billion. It, too, has little cash on hand to meet future redemptions. Similarly, Wasatch Ultra Growth WAMCX , with a potential capital gains exposure of 45% and almost no cash, has had net outflows of nearly $60 million over the past year, bringing assets down around $110 million. These are extreme but not isolated examples. There are several other funds with a particularly potent combination of potential capital gains exposure greater than 40% , almost no cash, and significant outflows over the past year that have persisted in recent months. They include Columbia Acorn USA AUSAX , Columbia Acorn Select ACTWX , Ariel ARGFX , Fidelity Growth Company FDGRX , Royce Premier RYPRX , and Fidelity Small Cap Value FCPVX . Unlikely but Not Impossible A fund with high potential capital gains exposure that also has a low-turnover strategy and net inflows is less likely to make significant distributions. Vanguard Tax-Managed Capital Appreciation falls into that camp, as do names such as ClearBridge Aggres- sive Growth SHRAX (with a potential capital gains exposure of 64% ), Baron Growth BGRFX ( 58% ), and Sequoia SEQUX ( 55% ). Those funds also have some cash at the ready—particularly Sequoia, with a 20% stake. A high cash stake is no guarantee that a fund won't be selling stocks. As we reported last November, cash-heavy Longleaf Partners Small-Cap LLSCX distributed about 15% of its net asset value in 2013 , because its managers were selling holdings deemed too pricey. While shareholders may have been unpleasantly surprised, the move made sense given Longleaf's pessimistic view of valuations. Unless a strategy is specifically designed to minimize taxes, sizable distributions are always a possibility. œ Contact Laura Lallos at laura.lallos@morningstar.com

Many stock funds in the Morningstar 500 are cur- rently sitting on a substantial amount of capital appreciation. More than 100 of them had a potential capital gains exposure of 33% or more at the end of May—which means embedded capital apprecia- tion accounts for at least a third of their asset bases. That's not a bad thing, per se. Those gains won't necessarily be realized and distributed to shareholders. In fact, a high potential capital gains exposure is generally a positive indicator that a fund has both earned a nice return and been tax-effi- cient in the process, usually by keeping turnover low and sometimes by intentionally taking taxes into account when trading. Vanguard Tax-Managed Capital Appreciation VTCLX , which aims to mini- mize regular taxable distributions, has a potential capital gains exposure of 49% . You wouldn't want to buy into a fund and then get hit with a distribution of gains you weren't around to enjoy, however. While a low-turnover fund isn't likely to suddenly sell off a significant portion of its port- folio, sometimes a manager's hand is forced in order to raise cash to meet redemptions. And many stock funds have been in steady net redemptions over the past year. Triple Threat Westport Select Cap WPSRX might be a perfect storm. It has potential capital gains exposure of 70% , the highest in the 500 . On top of that, shareholders have been selling out; the fund has had nearly $120 million in net outflows over the past 12 months, a significant chunk of its asset base, which is now below $400 million. Finally, the fund had almost no cash reserves as of the end of March.

What is Red Flags? Red Flags is designed to alert you to funds’ hidden risks. Such risks can take many forms, including asset bloat, the depar- ture of a solid manager, or a focus on an overhyped asset class. Not every fund featured in Red Flags is a sell, and in fact, some are good long-term hold- ings. But investors should be prepared for a potentially bum- pier ride in the near future.

The pent-up gains at Royce Low-Priced Stock RYLPX aren't quite as high at 31% , but it has seen