Picking Mutual Funds On Pretax Ranking Could Be Misleading

LIKE alchemists in a medieval laboratory, agencies that track mutual funds are constantly experimenting with numbers to find better ways to assess a fund's performance.

Their latest tinkering has turned up the idea of rating mutual funds according to after-tax earnings rather than pretax returns.

For investors - already faced with a choice of more than 4,000 funds and showered with tables and rankings - this may seem just a further complication. But factoring tax into a fund's return can dramatically alter its rating.

For instance, the SunAmerica US Government Securities Fund - a general government bond fund - has earned its investors a 6.41 percent average return over the past three years, according to the Morningstar Mutual Fund rating service. After tax, however, that already low return drops to 4.02 percent, leaving shareholders to pocket a mere 62.8 percent of the pretax return.

Two Stanford University professors, who completed a study of mutual fund returns before and after tax, confirm that some top runners lose their luster after tax. But the reverse is also sometimes true. For instance, the Franklin Growth fund ranked only in the bottom 20 percent of funds on a pretax basis, according to Profs. John Shoven and Joel Dickson. But after they applied the tax of a high-income investor to all the funds' returns, Franklin jumped to the top 40 percent. The professors conclude simply: ``Pretax rankings, which are published regularly in all the major financial magazines, are inappropriate for providing necessary performance information to taxable investors.''

Last June, Morningstar in Chicago began publishing a tax analysis of each fund, including tax-adjusted historical returns, as well as what it calls the funds' ``potential capital gains exposure.'' This is a ``worst-case scenario,'' explains Morningstar analyst Laura Lallos, meaning if the funds were liquidated right now.

For mutual fund investors with tax-deferred accounts like 401(k)s and individual retirement accounts, savings accumulate untouched by tax until retirement. For most mutual fund investors, however, tax is a factor. And how a fund distributes its earnings is key to how much tax an investor pays.

Mutual funds make money for their investors in three basic ways: through interest and annual dividends on company stock in the fund's portfolio; through selling off stock at a profit; and through the rising value of the stock remaining in the portfolio.

From the taxman's perspective, the first qualifies as income, the second as capital gains, and the third as unrealized capital gains, which remains untaxed as long as the investor holds onto the shares. The investor in the top tax bracket gets 38 percent sliced off his mutual-fund income distribution, but a less-daunting 28 percent off his capital gains distributions.

So-called tax-efficient funds tend not to distribute income and follow a buy-and-hold strategy when acquiring stock for a portfolio. This cuts down on the annual capital gains liability. Some aggressive growth funds, on the other hand, can turn over stock at more than 200 percent a year.

The SunAmerica fund is not a tax-efficient example. As Ms. Lallos explains, SunAmerica has had capital losses for the past two years while continuing to pay out income to its shareholders. The result has left shareholders out of pocket, Lallos say, by ``paying tax on more return than they actually got overall.''

Looking at a fund's tax liability, however, can be misleading, Lallos cautions. Some of the worst-performing funds often have the largest capital losses, which can be a plus, she says. For instance, the Dean Witter High Yield Securities Fund racked up such severe losses in the 1980s that its capital gains exposure is currently minus 160 percent of assets. But this appalling performance can offer shareholders a temporary tax shelter.

``It can be a good thing to have losses on the books,'' Lallos says. ``These can be applied to current gains as a tax write-off.''

Since 1990 the Dean Witter fund has made a turnaround, putting new investors in a strong tax position for future growth.