As winter is right around the corner, many people are thinking about skiing or celebrating the holidays. Many mutual fund investors with taxable accounts, however, have other things on their mind, mainly, "Should I buy this fund before distribution season?"

Mutual funds, by law, are required to distribute at least 90% of profits to their investors. They often distribute the bulk of these profits around the end of the year in what is known as a capital gain distribution. This process can often have serious, negative repercussions for individuals who hold funds in their taxable accounts. (Funds held in tax-deferred accounts such as IRAs are unaffected by distributions.) A good example of this is Fidelity's New Millennium fund, which recently announced a distribution of $11.20 in long-term capital gains, which is a whopping 30% of its NAV (36.65). If an investor had bought into this fund before it distributed, they would have been hit with a hefty tax bill - without having enjoyed any of its gains.

Naturally there is no way of telling what the exact distribution amount will be weeks or even months before the fund actually distributes. While many fund companies provide estimates a month or two before distributions, even this number can change due to factors such as fund flows (assets being moved by shareholders in or out of the fund).

So what if you want to have an educated guess of what an upcoming taxable distribution may look like so you can avoid buying into a fund with new money?

At Kobren Insight Management, we look at a variety of factors that can help estimate what a distribution may look like. These estimates are unlikely to give you a precise number, but they can often help avoid buying into an especially large distribution.

The following are a few guidelines to help you avoid such a situation. While capital gains are comprised of both short and long-term gains, for the sake of simplicity we can aggregate them as total capital gains.

The first thing to look at is historical tax efficiency. Chances are, if a fund has been tax efficient in the past, it will continue to be in years to come. The tax cost ratio is a quick way of finding out how tax efficient a fund has previously been. To calculate the ratio take the dollars paid in taxes (total return before tax - total return after tax) and divide by the ending value. For example, if an investment of $10,000 grew 20% to $12,000 and the gain was taxed at a long-term rate of 15%, the taxes paid would be $300. The tax cost ratio would be $300/$12,000 = 2.5%. By comparing the tax cost ratio to a few other funds in the same peer group you can begin to gauge if the fund manager is tax aware.

Second, portfolio turnover provides insight into how much a fund manager actually trades. A low turnover ratio suggests a buy and hold strategy, whereas a high turnover indicates considerable buying and selling. Many mutual fund investors often attribute higher taxes with high turnover because they think the manager is always selling at a gain. However, if a manager is tax aware and sells at a loss, the end result may be lower taxes as opposed to higher ones. A good way to see if this is indeed the case is by looking at turnover and historical tax efficiency together. If a manager has been tax aware in the past, but shows a high turnover for the current year, capital gains may be less of a concern.

Third, potential capital gains exposure provides an estimate of the extent to which a fund's assets have appreciated. If a fund has few tax-loss carry forwards (positions previously sold at a loss) and its assets have appreciated over the past year, there is a good chance of capital gains to come. Conversely, if a fund's assets have not significantly appreciated or the fund has a cushion of realized losses to offset its winners, then capital gains should be considerably smaller. The potential capital gain exposure metric takes these variables into account and provides the investor with an estimate of the percent of a fund's assets that could potentially be sold at a gain.

Fourth, if a fund has had a change in management leadership it may be a sign of vast portfolio adjustment. When a new manager comes to a fund it is not uncommon for them to sell some of the old holdings and insert their own investment ideas. This potential selling spree could spark capital gains as some of the positions sold may have been winners. A change in leadership is a significant event, and if you follow your funds it will be hard to miss. However, an easy way to check is by looking at Portfolio Manager Tenure when deciding to purchase a fund.

Finally, monitoring asset flows sheds light on whether a manager has to sell positions out of necessity. If a fund has seen large outflows then the portfolio manager may have to liquidate positions in order to redeem previous investments in their fund. This could result in selling positions at a profit, which would lead to capital gains. On the other hand, if a fund has had stellar performance and has attracted assets from new investors, capital gains from winning positions would be diluted by these new investments.

We consider all these variables when evaluating a fund's year-end distribution. Returning to the example above, Fidelity New Millennium, it became clear to us that this is a fund that warrants close scrutiny. That's because long time manager Neal Miller (he ran the fund for almost 15 years) stepped down on July 3, 2006, making way for the new manager, John Roth. In addition, the portfolio turnover ratio also raises concern. New Millennium's turnover has been considerably higher than its peer group, 120% and 100%, respectively. (As previously stated, it may be wise to view turnover within the context of historical tax cost ratios. In this case, however, this method is invalid as historical tax ratios cannot provide insight into the new manager's investment style.)

When comparing net assets in 2005 to 2006, we see a net outflow of 37%, which further increases our suspicion of a sizable capital gains distribution. Although only three of five metrics jump out at us while forecasting capital gains, they are enough to make us think twice about purchasing this fund prior to its distribution.

A general rule of thumb when buying into a fund that may distribute is to postpone your purchase date by one week for every one percent you expect the distribution to be. For example, if a fund company informs you that a fund will distribute 5% of its NAV, holding out for five weeks may be prudent. As stated previously, these rules and metrics are not meant to predict capital gains, but merely give a "heads up" when buying funds around distribution season.

So remember, while you're planning that ski trip out west or putting up decorations this holiday season, keep your eye on capital gain distributions so you can afford to spend a few more dollars on that new pair of skis or that dangerously bright reindeer on your lawn.

-- Vadim Levin