The Opportunity That The Bear Created

In the April issue of MoneySaver, I wrote about buying a fund that has accrued gains from past successes. We saw that this issue is not one of double taxation, but rather of timing. In this follow up piece, I’ll expand upon the tools used by fund managers to soften the mutual fund tax burden and look at the tax-related opportunity that exists today thanks to a painful bear market.

Capital Gains Refund Mechanism (CGRM)

Mutual funds don't pay tax directly. They are known as "flow-through" entities and, as such, flow-through all of their taxable income to investors to avoid paying taxes at the trust level (i.e. top marginal rate). Hence, all income (interest, dividends and capital gains) net of fund expenses is taxed in the hands of fund unitholders. There are two ways in which mutual fund unitholders can trigger a capital gain. First, the individual can sell his fund units for a profit. Second, the fund manager can sell securities within the fund at a profit, and then distribute that gain to unitholders in the form of a capital gains distribution.

The CGRM is a complex set of tax law provisions that sets out a formula to determine the amount of a mutual fund's capital gains realized in a year that can be kept in the fund (i.e. not distributed) without attracting tax. Theoretically, it is designed to prevent taxing the same capital gain twice - once when taxable investors sell units for a gain and again when the fund distributes capital gains to unitholders due to profitable stock selling.

(Note: Since part of the unit price is made up of stocks with accrued gains, the same gain is likely double-counted.)

The formula has many flaws, some of which work in favour of the mutual fund trust, and others that work against it. The flaws result from the gap between the CGRM's calculated estimates (which are based on year-end accounting figures) and actual experience. It is important to note that in order for the CGRM to have any impact, a mutual fund must have realized some capital gains from selling securities and there must not be an unrealized loss on the portfolio as a whole, at year-end.

CGRM may shelter more than just realized gains when:

CGRM may not be able to shelter as much as it should if:

Harvesting Losses

Harvesting losses is simply the strategy of crystallizing paper losses on existing stocks to offset gains realized on other profitable stock sales. AIC Advantage II did this to avoid paying a distribution in 1999. It had almost no cash at the beginning of that year, but was mired in a persistent string of redemptions. To meet redemptions, it sold some of its most liquid holdings, which also happened to be those with the largest accrued gains. Hence, they realized gains and had essentially wiped out most/all of the fund’s unrealized gain, which meant that the CGRM would not have prevented a distribution that year. Hence, triggering significant capital losses during the second half of 1999 is what prevented a distribution that year.

No one fund company is unique is its use of such strategies, though it’s fair to say that some firms are more tax-sensitive than others.

Capital Losses – The Opportunity

When funds realize capital losses, they simply keep them in the fund for carry forward to future years. Funds that have: a) lost money over the past few years, and/or b) experienced significant net redemptions may possess some hidden value in the form of tax loss carry forwards; that is if they’re otherwise decent funds. The value of future sheltering power only applies to taxable investors, of course.

Table I below highlights funds that fit this description.

Table I - Loss Information on Selected Funds
Fund MER^ Cap Loss as % of NAV* NonCap Loss as % of NAV* Accrued Gain (Loss)* Total Sheltering Potential**
AGF Aggressive Growth 2.57% 175% 8% 6% 177%
AIC World Equity 2.41% 35% 1% (28%) 64%
CIBC Global Technology 2.79% 283% 8% (30%) 321%
StrategicNova Cdn High Yield 2.59% 191% 0% (19%) 210%
Talvest Global Science & Technology 2.71% 161% 2% (48%) 211%
Trimark Enterprise Small Cap 2.83% 67% 9% (45%) 121%
^Source: Morningstar Canada (Paltrak 98)
* All figures are as of December 31, 2002, except for those pertaining to AGF Aggressive Growth – which are current to March 31, 2003.
**Calculated as: Cap Loss + Non Cap Loss – Accrued Gain (Loss)


Table I shows selected funds and their capital and non-capital loss details. The largest funds in the country don’t have such large losses to carryforward. Even the few that do tend to have posted good performance so far this year, reducing opportunities for investors to jump in now to enjoy potential tax benefits.

(Note: CIBC and Talvest funds are virtually identical, though the former offers much greater sheltering potential of future gains.)

Capital and non-capital losses can be carried forward indefinitely and for seven years, respectively. Of the funds noted above, the following funds are worth considering for taxable portfolios based on the loss carryforwards and recent fundamental changes.

AIC World Equity

Under former management, this fund was positioned to benefit from one scenario: a European bull market. Relatively new lead manager Anne Mette De Place Filippini and co-manager Geoff Castle have finished the ‘sell’ side of the transition process, which involved about half of the portfolio. A handful of new positions have since been added, but cash still hits at more than ¼ of the assets.

They’d love to get more money invested, but not until they find a sufficient number of stocks that meet their price and quality criteria. Expect the fund to emerge as a true EAFE portfolio with broader sector diversification and greater downside protection on valuation. Holdings like HSBC, Nestle, and Tesco anchor a portfolio that currently trades at a weighted (trailing) P/E of about 16 times.

Frustrated unitholders should take some comfort in the changes on this fund. And taxable unitholders will be happy about its ability to shelter a substantial amount of future gains.

Strategic Nova Canadian High Yield

Bond veteran Barry Allen, of Marret Asset Management, has reinvigorated this former Strategic Value fund. Previously the high yield specialist on Altamira’s successful fixed income team, Allen has been opportunistic in taking advantage of the huge credit spreads among some riskier high yield debt issues – a move that proved beneficial as prices have risen dramatically since last fall. While interest will continue to flow through to the T3, future capital gains will long be sheltered thanks to a mammoth capital loss carryforward. The fund is expensive but taxable investors may want to consider the tax benefit of sheltering many years of capital gains – which this fund should be able to do.

Trimark Enterprise Small Cap

Formerly managed by Lynn Miller of C.A. Delaney Capital, this fund had suffered punishing losses as it jumped back into tech stocks much too quickly (in 2001). Tough times persisted on this fund until this past spring, when Rob Mikalachki (manager of this fund’s more successful sister – Trimark Canadian Small Companies) was put in charge of this wounded puppy. It’s closed to new investors (like its sister) but those still holding this fund in a taxable account should sit tight because it’s a good fund with lots of tax sheltering potential. While it’s more expensive than Canadian Small Companies, the potential tax benefit should be worth much more than an extra 0.35 percentage points.

Fund Mergers

With the proliferation of fund merger proposals, taxable investors should pay special attention. The benefit of loss carryfowards can be lost in the event of a fund merger – a common occurrence these days. Section 132.2 of the Income Tax Act states that capital and non-capital losses of a ‘terminating’ fund must be used up in the taxation year in which a fund merger takes place.

Hence, the next time you receive a proxy to vote on a proposed fund merger, pat attention. Check out the latest financial statements on the fund being merged into the history books to verify its losses available for carryforward. Fund companies may want to preserve the fund with the better track record, but taxable investors will want to keep the fund with the greatest potential to shelter future gains.