A late-year slide in Asian stock markets led to a 9.4% loss for the $2.3-billion Templeton Developing Markets I fund in 1997. But you wouldn't know it from the tax statements the company sent to shareholders.

Despite the loss, Templeton Developing Markets paid out 84 cents a share in net capital gains to investors, on top of 15.5 cents a share in dividend income. Nor was the Templeton portfolio unusual in this regard. Dozens of other foreign-flavored funds, such as Merrill Lynch International Equity and New England International Equity, also handed a tax liability to shareholders despite posting negative performance for the year.

So did a few funds in domestic categories like Prudential Natural Resources. Intuitively, it seems odd that fund companies would distribute taxable capital gains to shareholders in down years. More than a few shareholders scratch their heads when it happens.

"People don't like the idea of paying taxes on something showing a loss for the year," says Tony Farina, an Edward Jones broker in Douglasville, Ga. That's why it's important for brokers to explain to clients how mutual fund taxation works.

Gains, Losses and Performance First, investors need to realize that mutual funds themselves aren't taxed on investment profits--shareholders are. Funds act as tax conduits, passing through the consequences of taxable gains and losses. Each year, fund companies must tally up all of the profits and losses from securities sold in preparation for sending a tax statement to investors. When winners exceed losers--as is typically the case--the fund will pay out a net realized gain. When losers prevail, which hasn't been very common during the past three years, the fund has a net realized loss.

The tax code prevents investors from deducting net losses on their tax returns, but a fund can use these deficits to offset profits in future years, thereby sheltering a portion of gains from taxation.

What makes tax accounting for mutual funds confusing is that gains don't always correspond to good performance during a year, just like losses don't always correlate with negative returns. Funds that sold more winning stocks during the year while hanging onto losers would distribute a taxable gain to shareholders, even though their total returns might be in the red.

The maddening aspect of mutual fund taxation is that some of those gains might have been realized from profits derived in earlier years. This explains why people investing in taxable accounts generally don't want to commit new money shortly before a fund pays a distribution, typically in December.

Investors who do so essentially are buying the tax bill incurred by other shareholders. Worse yet, clients who get in late in the year might show a loss even if the fund itself is up for the year, notes Tim Paulin, manager of advisory research for Dain Rauscher in Minneapolis.

Brokers need to make sure that clients are aware of the problems posed by distributions. They also need to make sure that clients who reinvest taxable distributions into additional shares keep good records over the years so that clients can use the most advantageous tax calculation.

Brokers also may need to prepare clients to keep some liquidity in their accounts come April 15. "You need to make sure that clients are aware of an impending capital gains payment and that they have enough money set aside that they can pay the tax bill," says Paul Husted, an Edward Jones broker in Great Falls, Mont.

Encourage some planning late in the year when you still have an opportunity to sell losing positions to offset taxable gains. "Most people will need and want those losses if they have other capital gains distributions that they may need to offset," says Neil Burns, a broker and attorney at LPL Financial in Mission Viejo, Calif.

Remedies and Options But even clients who plan ahead may wind up with a tax bill on capital gains distributions--and may be upset about it. For these people, brokers can suggest several courses of action.

First, of course, they can suggest that clients avoid putting new money into funds late in the year, before a distribution has been paid."The time to deal with this tax problem is back in October or November," says Burns. "We don't want to put clients into something where they'll quickly get their money back on a taxable basis."

Second, brokers can use distribution discussions as a way to encourage the use of tax-sheltered accounts. "If people have a pressing need to protect their money from taxes, there are plenty of ways to do so through variable annuities, IRAs and muni-bond funds," says Farina.

Third, steer clients into tax-efficient funds.

Burns and Husted both consider tax efficiency, especially turnover, in selecting mutual funds. "If the turnover is high, it not only raises questions of tax efficiency but makes me wonder what kind of investors the managers are," says Husted.

Carryforward Caveats And what about taxable losses? Although investors can't deduct a fund's net realized shortfalls, they can buy into funds that will be able to apply those deficits to offset capital gains distributions in future years.

Reflecting the lengthy bull market, it's much more common for funds to distribute taxable gains than to incur losses. But losses could become more prevalent if the market stagnates.

"It has been a long time since investors lost a lot of money," says Burns. "Maybe this year will be different."

When a fund realizes a net loss for the year, it can apply this amount to reduce or eliminate net profits for up to eight years. Such tax-loss carryforwards can be a boon to shareholders by sheltering some profits down the road, as happened when high-yield bond funds recovered from their slump of 1989-1990.

The problem is that it can be hazardous to invest in funds simply because they have a tax-loss carryforward to apply. "It's hard to find good funds that don't have a capital gains exposure," says Paulin. "Some funds that are in a loss-carryforward situation are there because they have crummy managers."

One reason mutual fund taxation can be tricky is that two holding periods are involved--that of the portfolio itself and that of the shareholder. While investors can't do anything to affect the timing of gain and loss realizations at the fund level, they enjoy plenty of flexibility in determining their own holding periods.

For starters, shareholders can hang onto their investments indefinitely and defer taxation until they sell, except for any distributions the fund passes along. In fact, a shareholder may be able to completely shelter gains forever if he or she dies while still holding the investment, as some if not all of the unrealized tax liability could be eliminated with a stepped-up tax basis at death.

Also, investors can time their sales of fund shares to trigger any of three tax scenarios. Ordinary income taxes would apply to profits on investments held one year or less, while preferential capital gain taxes, at a top 20% rate, would kick in on shares held more than 18 months. Between 12 and 18 months, a maximum 28% mid-term rate would apply.

Finally, investors can employ any of four distinct accounting approaches to determine their tax bill if they make only a partial redemption of fund shares. These methods are known as: first-in, first-out; average cost (single category); average cost (double category); and specific identification. The latter category offers the most flexibility from a tax standpoint, while first-in, first-out usually results in the highest tax bill, at least during bull markets.

The interest in investing in emerging markets has grown exponentially of late, with most financial advisers allocating at least a portion of client portfolios to securities traded outside the United States. Like an exuberant tourist just back from a trip, stories abound of huge profit potential, zooming stock markets and lands poised for economic turnaround.

But wade through the muck, and you'll find that emerging market gains sometimes mean very little to investors. Those who invest in emerging markets say trading volume is still relatively thin, and the cost of a retail trade in an emerging market exchange is hefty--so much so that it's often not worth the price.

Institutional investors active in markets overseas often stage their purchases or sales of investments in emerging markets. But such progressive buying or selling won't get you out in time when a situation like Hong Kong or Korea drags down prices.

Retail investors are warned to invest in emerging markets through mutual funds or ADRs. Why? A big reason is the currency translation. Trades have to be settled in the currency of the foreign market, and that's an extra expense.

"If you are buying local shares, you have to buy the currency, too," says Steve Bleiberg, managing director of BEA Associates, an international investment firm in New York City. "So that means a separate currency transaction. You lose a spread on both sides of the trade, and on small trades it could be extremely high"--5% to 10% could be lost, he says. "I can't emphasize enough that people who want to buy local shares in local companies should stick to ADRs."

Bleiberg and other pros who normally operate in emerging markets also warn about custody. After the trade is done and settled, the issue of where the shares are to be custodied comes up. Most emerging market countries do not have automated systems and still require shares to be physically registered and held at a local bank or brokerage.

"In some of these countries, they are just kept locked up in a safe-deposit box at a bank," says Radhika Ajmera, head of Emerging Markets-Asia investing at Aberdeen Asset Management in London. "The custody issue is a big one." She says that the physical transfer costs are expensive--averaging about 1% of the amount of the trade.

On top of that, there are high trading costs. "Commission rates, even for institutions, are between 75 basis points and 1% just to deal," says Ajmera. "In small lots, that becomes very inefficient."

Big Gains, Bigger Risks Investors may be little dissuaded by one or two percentage points in higher costs when they see market gains of 100% or more. For example, the Morgan Stanley Country Index for Turkey posted a 112% increase for 1997. But Ajmera says Turkey's index is comprised of just 30 stocks, of which the largest accounts for 30% of the index. "It's terribly concentrated," Ajmera says. "If you were to invest in another company there, you'd be hard pressed to get that type of return."

Another shining example of big reported returns is Russia. In 1997, the market was up about 75%, according to the Moscow Times Index. In 1996, the gain was about 85%. But the risks there are enormous in terms of trade guarantees, pricing and custody. "In Russia, we only invest in ADRs," says Ajmera. "It's a nightmare to invest in local shares. Our own custodian will not even give us guarantees that our shares will even be there." Corruption, she says, is the biggest risk factor in Russia. In other countries, too, the custody issue of shares makes trading problematic.

"In some cases the physical shares have to be sent to the company to be registered," says Bleiberg. "That can take weeks. And during the whole time, you can't sell because you have no physical shares to present."

Hal McIntyre, managing partner of N.Y.-based Summit Group, which specializes in consulting on international securities operations and custody issues, says the world's stock exchanges are trying to get to a T+3 environment. But, he says, "Each country is different. They are all trying to get to T-3. But for many it's still T-5, and in some cases it's T-monthly."

And of course, during a settlement period, you're helpless--you can't maneuver in or out of a position. That can be an especially painful experience given the fact that in some countries, insider trading is legal, McIntyre notes. "So if everybody else knows something and gets out, you could be left holding the bag with no recourse."

Because of the costs and intricacies of investing in emerging market countries, it's easier and cheaper for retail investors to turn to experienced institutions, say advisers. Tom Lydon, president of Global Trends Investments in Huntington Beach, Calif., recommends mutual funds that have an established track record in a region. "They understand the volatility," he says.

And volatile these markets are. Russia had daily trade flow of between $200 million to $300 million last year, according to Ajmera. Early this year, volume had dropped to $40 million to $50 million a day. Hungary, she points out, is down to about $15 million of daily trade flow from $80 million last year.

"It's why they call these markets volatile," Ajmera says.

Volatility in the context of thin markets doesn't leave much room for investor error. Liquidity can dissipate rapidly. Even in a roaring bull market perhaps only a few concentrated positions will bring home solid returns. And with emerging markets continents away, playing by their own home-grown rules, clients should consider carefully if those reported big gains aren't worth going after.

Even if your firm has a branch in the foreign market, you need to have a broker who has a seat on the local exchange. If your firm doesn't have a seat, this will run about 75 basis points. The order is placed via fax or phone. Then, money is wired. Local currency is bought--with a spread of about 5% being typical. The trade is executed at spreads that vary or are unknown since many shares are illiquid, trade rarely and have no quote. Receipt of confirmation is sent via phone, fax or E-mail. Shares are issued in the client's name or an omnibus account. Custody of the shares is taken by a local bank or brokerage, which will charge around 1%. Hard copies of the receipt and confirmations are mailed. Traditional back office operations ensue.