Paying capital gains taxes may be an inevitable result of successful investing. But the longer you can delay the inevitable, the greater will be your ultimate success.
Sector funds offer aggressive investors the best of both worlds.
They combine the risks of normally high volatility and concentration in a single industry, with the safety of a managed portfolio.
Armed with this protection, you can use sector funds to add some trading zip to your portfolio while enjoying the safety of diversification.
Traders thrive on volatility. And if you check the top-ten lists for mutual funds in the financial press, you’ll find plenty of sector funds.
Of course, if you check the bottom-ten lists, you’ll find plenty of sector funds there too.
Active traders, however, face more than the obvious problems of buying low and selling high. Transaction costs and taxes on realized gains outside of a registered account can significantly reduce profits.
That’s why traders may find so-called “corporate class” funds appealing. These are designed to let you switch between them without generating capital gains for tax purposes. They’re not like ordinary funds, which are organized as mutual fund trusts.
When you invest in an ordinary fund, you buy securities of the trust. The trustee holds the actual title to the cash and securities owned by the fund on your behalf.
But in Canada, a mutual fund can also be established as a mutual fund corporation. And when a fund company sets up several of these types of funds, they can constitute shares of a single mutual fund corporation.
The tax consequence of an investment in one of these corporate funds depends in part on the tax position of the corporation as a whole. And this generally differs from a mutual fund that doesn’t use a corporate class structure.
The tax consequence of chief interest to most investors concerns switches between funds. When you switch your securities of one corporate class fund for another, the switch occurs on a tax-deferred “rollover” basis. That means you don’t realize a capital gain or a loss on the switch.
Keep in mind, though, for tax purposes, the cost of the new securities you acquire on the switch will generally be equal to the adjusted cost base of your original securities.
So if you choose to redeem your second fund and you incur a capital gain while doing so, you have to calculate your gain using the adjusted cost base of the first corporate class fund you bought.
A less attractive potential tax consequence of owning a corporate class fund may occur if there is too much switching between these funds.
In such cases, because of the corporate-class structure, you may find that you have to recognize a gain at an earlier time compared to a mutual fund that does not allow tax-deferred switching.
Keep in mind, too, that a fund corporation is liable for each of its funds’ expenses. That means if one fund cannot pay its expenses, then other funds in the corporate organization are liable for these expenses. This could hurt the value of your investment.
Finally, note that the management expense ratios of corporate class funds tend to be higher than those of their trust fund originals. That’s why long-term investors are better off sticking with the trust version of funds.
And remember, while the tax advantage in corporate class funds has value for the active trader, sooner or later you’re bound to pay taxes on gains – those realized in the funds when you get a distribution, and when you sell out of them altogether and realize a profit.
If you like to trade, you can get plenty of excitement with sector funds.
The MoneyLetter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846