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Tuesday, August 5, 1997
Tax reform to expand short-term trading by mutual funds
Analysts agree repeal of 60 year-old law is good news for
investors
by Michael Brush
If you notice the amount of trading in your mutual fund
shoot up over the next several months, don't be alarmed;
your fund manager has not lost his marbles.
Your manager may just be taking advantage of the repeal of
an arcane 1930s rule which many fund analysts say has put
too much restraint on short-term trading by mutual funds.
Under the old law -- which no one quite understands the
reason for -- mutual fund managers have been prohibited
from earning more than 30% of their gains from the sale of
securities held for less than three months. Exceed that
limit, and the fund loses its "flow through" tax status,
which allows fund profits to pass directly to shareholders
without being taxed until shareholders declare the income.
After years of lobbying by the mutual fund industry, this
so-called "short-short" or "short-three" rule will be
repealed when President Clinton signs the current budget
plan into law.
At that point, mutual fund managers will have a lot more
freedom in managing their portfolios. In some cases, that
will mean larger returns for mutual fund investors.
The change will have the biggest impact on the high-
turnover aggressive growth funds, momentum funds, and
quantitative funds that manage money in part by following
sell signals from computer models. It will also be good
news for managers that like to use short positions or
hedging instruments -- the gains from which are almost
always booked as short-term earnings.
"We believe we have lost substantial returns for our
investors in the past as a result of compliance with this
test," says Edward Pittman, the president of the
Quantitative Group of Funds.
"Last year, for example, several of our fund managers were
forced virtually to shut down their portfolios in the latter
months of the tax year, in order to meet the requirements
of the code. Stocks with short-term gains were kept in our
portfolios even though our models were generating strong
sell signals."
Fund managers and advisors throughout the industry
welcomed the change. "I think this is good news for me and
for investors," says Fredric French, who manages the
Investors Research Fund. "I will no longer have to pay
attention to whether I have held stock for the magic three
months."
"The rule had become a trap for the unwary," agrees Seth
Rosen an attorney specializing in mutual fund laws at
Debevoise & Plimpton. "And in some cases it prohibited
fund managers from doing things they wanted to do."
The change will be particularly useful in a sharp downward
move in the market, because funds will be able to close out
positions in rapidly falling stocks, without having to worry
about realizing too many short-term gains. "A number of
funds got caught up by this in the 1987 market decline,"
notes Lawrence Friend, the chief accountant in the
Securities Exchange Commission's division of investment
management.
The repeal of the law will also be a big plus for managers
who like to take lots of quick short-term profits during
highly volatile markets, like those of the past six months,
notes Christopher Baggini, the manager of the ARK Capital
Growth fund.
It should also reduce some of the work load at fund
companies. "I suspect the number of hours spent keeping
track of all this throughout the mutual fund industry was
enormous," says French.
The change will also free up constraints felt by new funds
with a short tax year. By definition, they did not have
enough time to build up long term gains, so they were
blocked from realizing short term gains of less than three
months.
The repeal of the rule won't always increase trading at
funds, however. In some instances it will actually reduce
turnover dramatically. Take the case of the Investors
Research growth and income fund managed by French,
which had a whopping 670% turnover as of June 30,
according to Morningstar. That makes French look like an
active trader, but in fact most of that turnover was due to
French's attempts to comply with the 30% rule, he says.
How so? To get more room to realize short term gains,
French and many other managers have been resorting to a
practice known as "dividend capture." By buying securities
just before they pay dividends and selling them the next
day, these managers build up dividend income, which
counts towards long-term gains. And the more long-term
gains booked, the greater the base against which a fund
can rack up the 30% maximum short term gain. "It is an
artificial transaction that only changes the arithmetic,"
says French. "There has been a lot of artificial activity
going on to keep funds tax-qualified."
Many shareholders won't notice any change in turnover,
however, since the 30% rule was a rather liberal ceiling
for many investment styles. "A lot of funds won't be
affected simply because their managers are not wildly
trading," says out Laura Lallos, a senior analyst at
Morningstar.
As law moves off the books, a puzzling question remains:
Why did it exist in the first place? "No one is really quite
sure," says Bob Sherwood, a parner at Price Waterhouse
who specializes in mutual fund tax law. "There is no
legislative history, so no one really knows why it was put
in the law."
It is easy to speculate, of course, that the law was meant
to prohibit short term trading by funds. But with the
development of more sophisticated investment
instruments, the law became more and more of an
anachronism, says Sherwood. Hedging techniques like
shorting options and futures, and outright short sales of
stocks, are popular among many fund managers as
insurance against losses. But earnings from these tools are
almost always racked up as short term gains -- meaning
that the use of these hedging techniques always ran the
risk of pushing funds over the 30% limit.
Although it will permit more hedging, the removal of the
30% limit will not necessarily have a big effect on hedge
funds themselves. That's because most of them are set up
as partnerships and not mutual funds, and so they were
never affected by the 30% rule in the first place.
JW
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