If some index funds are "on sale" because they have potential capital losses instead of unrealized capital gains*, what about managed funds? Do they offer similar opportunities?

The short answer is "yes."

Using the Morningstar database, I found that the 7,643 managed domestic equity funds had an average potential capital loss equal to 58 percent of fund assets at the end of September. The comparable figure for domestic equity index funds is 45 percent.

The hard part is winnowing down the 7,643 funds to the most likely candidates for investment. Fortunately, a few simple screening measures reduce the list to a reasonable number. Here's what I did:
  • First, closed funds were eliminated (Why search for funds in which you can't invest?). So were funds requiring an initial investment greater than $10,000.
  • Second, funds with 5-year annualized returns lower than the S&P 500 Index were eliminated (Why search for a managed fund that does worse than a major index? This eliminates a great many funds.)
  • Third, funds with potential capital loss exposure under 45 percent were eliminated (Why look for a smaller tax loss carry forward than the average index fund when you're seeking the largest possible tax advantage?)
  • Finally, funds with less than $200 million in assets were eliminated (A $10 million fund can have a potential capital loss but new share purchases could swamp it. The only way to get a real benefit from a potential capital loss is to have it in a relatively large fund.)
This took the list down to 47 funds. Be advised, no computer screening is perfect. At best screens can reduce a random haystack to a small mound of logical candidates. The mound could include funds with absurdly high expense ratios that would offset any benefit. It could also include funds that took extravagant risk.

To cope with these factors, I created two scoring measures. The first simply measured the value of the funds' possible tax advantage from its potential capital loss as a multiple of its expense ratio. If, for instance, a fund had a potential capital loss of 100 percent of assets and an annual expense ratio of 1.0 percent, its advantage was that its capital loss would support 20 years of the current annual expense.

Then, I multiplied the advantage score by the fund's Morningstar rating. Under the Chicago firm's new rating system, this puts a premium on funds managed with low relative risk. The top ten funds in the resulting rank ordered list, include 5 no-load funds, 2 load funds, and 3 specialty funds.

The top score no-load fund candidates were Janus Mercury (large growth), TIAA-CREF Growth & Income (large blend), Janus Olympus (large growth), PBHG Large Cap 20 (large growth), and Strong Growth 20 (large growth). Janus Mercury (ticker JAMRX) performed in the top 8 percent of its category over the last five years but still has a potential capital gain exposure of minus 125 percent of its current $4.8 billion in assets, and a below average expense ratio of 0.88 percent.

Morgan Stanley American Opportunity A shares (large growth) and Van Kampen Emerging Growth A shares (large growth) were the two front-end load funds in the top ten. The potential tax benefit of the Morgan Stanley fund would cover its current annual expenses ( 0.81 percent) for 18 years. Evaluated another way, the minus 74 percent capital gain exposure means the fund has potential tax savings of 14.80 percent of current fund assets. That's nearly 3 times its 5.25 percent front-end load.

Finally, three specialized funds make the top ten: T. Rowe Price Media and Telecommunications, Fidelity Select Software, and MFS Utilities A shares. Only the T. Rowe Price fund is no load. A bottom-fisher in this $425 million fund would buy into a whopping negative capital gain exposure of 178 percent of current assets. (The funds and related data are shown in the table below.)
Ten Good Tax Advantaged Funds
The return is the 5 year annualized return; the rank is the percentile rank for funds in the same Morningstar category; potential capital gain is expressed as a percent of current fund assets; expense ratio is the annual fund cost as a percent of assets; M* is the funds Morningstar rating which scales from 5 (highest) to 1 (lowest); the front end load is as a percent of initial investment; and the score is a computed number that reflects the tax benefits of negative capital gains, the annual expense ratio, and the Morningstar rating.
Fund Name (ticker) Return (Rank) Potl CG ER M* Load Score
No Load Funds
Janus Mercury (JAMRX) 1.82(8) -125% 0.88 4 0 114
TIAA-CREF G&I (TIGIX) -1.00(27) -56 0.43 4 0 104
Janus Olympus (JAOLX) 2.97 (6) -107 0.89 4 0 96
PBHG Large Cap 20 (PLCLX) 3.65 (4) -178 1.25 3 0 85
Strong Growth 20 (SGRTX) 0.09 (13) -187 1.50 3 0 75
Load Funds
MS American Opp A (AMOAX) 0.05 (14) -74 0.81 4 5.25 73
Van Kampen Emer Grth A (ACEGX) 1.21 (10) -100 0.93 3 5.75 65
Specialized Funds
T.R.Price Media & Elec. (PRMTX) 3.44 (1) -122 1.08 4 0 90
Fidelity Sel Software (FSCSX) 2.67 (10) -111 1.05 4 3 85
MFS Utilities A (MMUFX) -1.37 (41) -108 1.11 4 5.75 63
Avg. Dom. Fund Na -58 1.5 2.9 Na 23
Source: Morningstar Principia, September 30, 2002 data; author calculations
The URL for the earlier column on this subject is:

Index funds carry new incentives