Q. You have shown that an index fund is not good for the small cap allocation of the portfolio.   Can you please advise what funds would work?   I researched and found a fund that looked good called Meridian Value, but articles seem to warn about the fact that it has grown tremendously in the last year, and may not be able to continue the performance. I found some others like Wasatch, but then realized that they under performed over the long run. Then I wonder, is it really necessary to invest in small cap, or is it good enough to just stick with the Couch Potato, as you have shown that the 75 percent Couch Potato portfolio worked better than most over the long run.   I am investing for 10 years.

---E.W., Minneapolis, MN

  

A. The moment you step away from an unmanaged index you are, once again, in the manager picking game. So I don't think the answer is in any particular managed fund. The problem with the small cap indices is that they have more "doors" than a large cap index. In a large cap index, growing companies enter and never leave. They displace companies that have failed to grow as rapidly. In effect, a large cap index fund has a "survivor" bias.

The same can't be said for other parts of the index spectrum. In a small cap index, such as the Russell 2000, many of the fastest growing companies are removed index each year because they have "outgrown" the index.   They are passed on to a larger cap index and take their performance with them. The Vanguard Small Cap Index fund, which mimics the Russell 2000 index, has been below the 50th percentile in every measurement time period--- 1, 3, 5, 10, and 15 years. That means managed funds have done better.

Rather than trying to find a small cap fund, I'd think about enlarging the scope of the index you use. You could, for instance, expand from the S&P 500 Index to the Russell 1000 Index. You'd miss as many as 6,000 publicly traded companies but you would still capture about 90 percent of market capitalization in America. And you would still be a passive investor rather than a segment player or manager selector.

  

Q. Per one of your recent columns, I did notice from the semi-annual report on the Templeton Foreign Fund about the unrealized appreciation. It stood around 5% of the cost of investments "for income tax purposes."   But what does this "unrealized appreciation" really mean? I guess it is similar to the unrealized capital gains that often cause me a lot of tax without actual investment benefits since they do not contribute to any investment return. Your clarification?

---C. Y. C., by e-mail

  

A. The subject of unrealized capital gains in mutual funds is one of the most difficult things for investors to understand. A good way to start is to remember that taxable events in mutual funds have two sources, not one:

•           When you buy the fund its net asset value per share (N.A.V.) may be                $10.00 but there may be unrealized net capital gains or losses.                Someday, somehow, those gains will probably be distributed to you.                In effect, you have "bought a tax liability." There is absolutely                nothing you can do about this except to avoid funds that have large                unrealized capital gains. With the fund you mentioned, a 5 percent                unrealized capital gain could eventually be translated into a                capital gains distribution that would cause you to pay federal                income taxes equal to 1 percent of your original investment. That's                not bad. Most people are concerned about this because they have                bought a fund and received a large distribution even as the N.A.V.                of the fund has declined.

•           The second source of taxable events is a lot more comfortable--- our                own sell decisions. We buy at a particular NAV and we hope to sell                at a higher NAV. Most people focus on these figures and forget about                the first, even though unrealized capital gains were in the fund long                before.