Body text: It's hard to imagine, but many investors of actively managed retail mutual funds are about to find out that the pain they've suffered from 2008's massive market losses is most likely to get worse.
The astonishing volatility of last year's stock and bond markets was fed partly by huge amounts of trading by the managers of retail mutual funds. There were two primary reasons for this. First: many investors panicked and sold their shares. According to TrimTabs Investment Research, investors withdrew $56 billion from their retail stock mutual funds in September -- a record level of withdrawals that was promptly exceeded the following month when investors sold $71 billion of stock fund shares. To meet the demands for cash, managers were required to sell many of the portfolio's securities.
The second reason is due to the managers' own behaviors. Seeking to reduce their funds' losses and hoping to generate elusive gains, many fund managers engaged in a frenzy of selling and buying in 2008. The result, according to Morningstar, is that retail stock mutual funds averaged a 2008 turnover rate of 89 percent as of November 31, 2008. This means that the average retail mutual fund had sold 89 percent of the securities it had owned the previous January 1.
Some sold more, others less.
So what? Here's what: Many of those securities were sold for more than their cost basis. That's a fancy way of saying that many securities sold by fund managers in 2008 had been purchased years ago at lower prices. Thus, despite 2008's decline, the shares were still worth more than their original purchase price. The result: a potentially hefty tax liability for investors.
Here's an example. Say a fund bought shares of XYZ Company in 2002 for $20 per share. The price rose to $50 per share by the end of 2007. That's when you invested in the fund. Then, in 2008, XYZ falls to $30 per share, a 40 percent decline from its 2007 high. The fund manager sells the stock, and the fund records a $10 profit (the difference between the price it paid to buy the shares in 2002 and the price it received when selling them in 2008). In accordance with IRS rules, the fund is required to issue a capital gains distribution for the $10 -- which you must report on your tax return.
So although you lost 40 percent on your investment, you have to pay taxes on your share of the fund's long-term profit.
Ouch.