Mutual fund managers come and go. It's just the nature of the business as companies look for the next superstar or shift top managers to underperforming funds in their family, or as managers simply leave the mutual fund industry. Be that as it may, such changes could mean bigger tax bills for you. In this article, we'll take a look at how a change in fund manager can affect the fund's shareholders.

SEE: The Advantages Of Mutual Funds

Style Shift

Generally, mutual funds will show capital gains after managers decide to make minor adjustments in the portfolio and take advantage of current and accumulated losses. However, when a new fund manager assumes control, he or she may not choose to take advance of those losses. Instead, a new manager might bring in a new management philosophy. For example, perhaps he or she wants to significantly reduce the fund's exposure to automotive stocks and buy more non-cyclicals, such as utilities. What happens? Auto stocks get sold, and profits are passed on to you - the shareholder - who is responsible for paying the associated tax.

This change could boost long-term performance, but it could also leave shareholders with lower net returns once they pay the tax on their capital gains.

A Tax Bill When You Didn't Sell?

You might wonder how you could owe tax if you didn't sell any shares and your fund is worth less than what you paid for it.

When a mutual fund sells securities for a profit, it must pay those profits to its shareholders in the form of capital gains distributions. The amount of the distribution is subtracted from the fund's net asset value (NAV). As a result, you don't gain anything, and it doesn't matter whether you actually take the distribution or reinvest it in additional shares - you still owe the tax.

For instance, imagine that you bought a mutual fund three years ago and the current NAV is below your cost. The fund manager sells a stock in the fund for a $5-per-share profit. You will receive your portion of the $5 profit, regardless of the fact that you are sitting on a loss. In January of next year, the fund company will send you a 1099-Div Form indicating the exact amount to report on Schedule D of your tax return.

What You Can Do:
Watch Your Portfolio Turnover Rate
A fund with a 25% turnover keeps its holdings for an average of four years, whereas a fund that has a 200% turnover gets rid of its securities every six months, on average. A management change followed by a big jump in the turnover ratio could mean higher capital gains tax for you, as well as higher expenses.

Here is a case of a mutual fund that had a turnover ratio of 152% in 2001. Over the next four years, however, it was cut by more than half to 72%. If the reverse had happened and the turnover ratio rose from 72 to 152%, it could be a cause for concern. You can find turnover data in a fund's annual and semiannual reports, prospectus or possibly on its website.

SEE: How To Interpret A Company's Prospectus

Check out the Fund's Capital Gains Exposure
See if your fund has accumulated losses from past years. This could eliminate or at least reduce the profits a fund realizes on securities sold.

Watch for Investor Flight
When a popular manager leaves a fund, investors sometimes panic. This could cause the crowd mentality to take hold, resulting in many shareholders wanting to sell. The next manager might be forced to liquidate profitable holdings to come up with the cash to pay selling shareholders. The result: capital gains for current shareholders.

Pay attention to media reports and the NAV of your fund's shares. If there is a lot of negative press and prices start to decline, it may be time to sell.

Immune to the Problem
Index Funds

Because index funds hold portfolios of securities representing those in a market index, management changes do not result in an investment strategy shift or large distributions to investors, unless a new index is chosen, which is not a common occurrence.

Qualified Retirement Plans, Traditional IRAs and Roth IRAs
Money that you hold in qualified retirement plans and Traditional IRAs grows tax-deferred. Assuming that you put in before-tax contributions, you will pay tax on 100% of your withdrawals. Funds in Roth IRAs grow tax-free, and the distributions are tax-free as well.

Consequently, mutual fund capital gains distributions within any of these accounts have no additional effect on your tax liability.

New Managers Not Always Bad News

When a new manager takes over, it's not necessarily a red flag to dump the fund. After all, the previous manager's returns may have been less than its category's average or benchmark index. Or the manager may have left for personal reasons that had nothing to do with his or her job performance. If the new manager was previously part of the old management team, there's a good chance that there won't be much of a change in the portfolio. The breadth and depth of management in a large, well-established fund company can usually provide for a pool of top quality talent to run a fund.

Nevertheless, if your fund changes managers every year or two, you should look closely as to whether you should sell the fund.

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