On December 12, 2017, many shareholders of the Oak Ridge Small Cap Growth Fund (ORIGX) got an early Christmas gift.

But for some of them, it was a lump of coal…

ORIGX was one of the premier mutual funds in the early 2000s. And it held many stocks at massive gains. But things started to change in 2009…

It underperformed the Russell 2000 Index in six out of the eight years during 2009 to 2016. Combined with its high fees, investors began to leave the fund in late 2017.

(At the time, the expense ratio on the fund’s class A shares was 1.4%, compared with 1.3% for the average small-cap growth fund… That’s relatively high.)

The exodus forced the fund to sell shares—and make a one-time capital gains payout of $22.77 per share. That’s great news if you were an early shareholder. But the massive payout sent shares down to $15.07 from $38 the prior day.

Of course, the distribution was taxable. But here’s the worst part for those who bought into the fund at a later date…

It didn’t matter whether they bought it at its low of $13.50 in 2009 and were up big… or if they bought it in 2015 when it was as high as $43 per share and were down.

All investors who held the fund in a non-retirement account had a taxable distribution of $22.77 per share. That’s a big tax hit… and a really low blow for those who bought in later and were sitting on losses.

I’m telling you this story because we recently received this question in our mailbag:

From Kunal G.: Hi, Nick. I love The Palm Beach Daily. Can you please write an article on mutual funds? For example, how to select them, what to watch for, and the tax implications, etc.

We get plenty of questions about mutual funds. So today, I’m going to tell you about one hidden danger you should look for when considering them… and how to avoid it.

Hidden Tax Dangers

We all know the IRS wants a piece of your gains. When you take a profit on a stock, you have to pay the taxman. It’s the same for investments you hold in a mutual fund.

But the tax hit can come as a shock—especially if you’re sitting on losses like some of ORIGX’s later shareholders. Here’s what I mean…

Let’s say you own a mutual fund that has an investment, ABC Company. The fund bought ABC at $10 per share. The stock zoomed to $90, and then fell back to $60—where the fund sold the stock.

The fund had a $50-per-share gain in ABC (the $60 sale price minus the $10 purchase price). So any investor who holds the fund would pay a capital tax gain of $50 per share… regardless of whether they bought into the fund at a low of $10 or a high of $90.

After such a large run-up in stocks, you could be buying into a mutual fund with massive capital gains and a large future tax payment—even if you took a loss on the investment.

Two Ways to Avoid an Unexpected Tax Bill

If you don’t want an unpleasant tax surprise, the easiest thing to do is hold your mutual funds in a 401(k) or an individual retirement account (IRA). Both types of plans are tax-deferred.

If you’re dead-set on owning a mutual fund in your taxable account, you can look at its annual or semiannual statements to see if it has accrued large capital gains. At the end of the statement, just check the “Schedule of Investments.”

You’ll see a row called “Total Investments.” Right under that row, you’ll see the cost of investments.

Take the cost of investments and divide it by total investments. If that number is smaller than 0.8, you might want to reconsider. This means there could be a large capital gains distribution in the fund’s future.

In the case of ORIGX, that number is still 0.67. That means it’s sitting on a large, 33% unrealized gain… and another future tax bill.

If you don’t want to go through all of that, another option is to find an exchange-traded fund (ETF) that’s similar to the mutual fund you’re interested in.

ETFs don’t have any surprise taxes like mutual funds. You just pay any capital gains taxes at the time of sale—just like you would with any other stock.

Thanks for the question, Kunal. I hope this helps you make an informed decision on the fund you want to buy.

Regards,

Nick Rokke
Analyst, The Palm Beach Daily

P.S. Stay tuned for tomorrow’s Daily. We’ll show you another danger lurking in your mutual fund. And if you have further questions about mutual funds, drop us a message right here. Just remember, we can’t give individualized financial advice.


IN CASE YOU MISSED IT…

On Wednesday, November 28 at 8 p.m. ET, PBRG co-founder Mark Ford is taking part in a rare and exclusive subscriber-only event: An Evening with Mark Ford, Bill Bonner, and Doug Casey.

As far as we’re concerned, this event should be mandatory viewing for all PBRG subscribers.

Because for the first time ever, Mark, Bill, and Doug are joining together for a candid conversation about their history, investing, the economy, and what they’re doing with their own money now.

There are also some incredibly valuable bonuses lined up for anyone who attends the event. (Including the opportunity to “partner” with Bill, Doug, and Mark in a brand-new venture.)

Which is why we’re inviting you to attend for free. (Join the VIP list here.)