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Aug. 25, 2003, 12:01 a.m. EDT

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By Erin E. Arvedlund

Scoreboard | Fund Scope | Cash Track

TWO MUTUAL FUNDS FOUNDED by market guru Martin Zweig are scrapping a decades-long tradition of making annual "fixed payouts" because of tax rules that will subject their investors to higher taxes in the future. And rumor has it that Zweig is so unhappy about the decision that he has threatened to quit the closed-end funds he helped found.

After getting his start as a newsletter writer and investment adviser in the 1970s, Zweig entered the fund business in the 1980s.

Today, he mostly runs hedge- fund money through his asset-management firm, Zweig-DiMenna, and he has little to do with the day-to-day operations of the Zweig Fund and Zweig Total Return /zigman2/quotes/203314618/composite ZTR +0.74% .

They and other Zweig mutual funds now are owned by Phoenix Investment Partners. But Zweig still lends his name to the funds, and apparently threatened to quit after their directors refused to reinstate the "fixed payout" at a meeting last week, according to attendees. Zweig didn't return phone calls seeking comment.

Zweig famously instituted the payout as a way to attract investors to the funds, and in recent months yield-hungry investors have once again flocked to the fixed 10% annual payment.

The funds play to investor preoccupation with yield by making quarterly cash distributions at an annual rate of 10% of net asset value a year, regardless of performance.

In years when the funds didn't earn capital gains and dividend income, investors got the 10% payout anyway -- a tax-free return of capital that came straight out of assets.

As a sales gimmick, the Zweig funds' payout also had the effect of narrowing the discounts from which many closed-end funds suffer. (A discount means the fund's share price trades at less than the underlying value of the stocks in its portfolio.) But Phoenix late last month informed shareholders that it was scrapping the idea. "By changing to a variable-distribution policy, we are reducing the potential for unnecessary additional taxes," wrote Philip McLoughlin, chairman of the board and president of the Zweig Fund. (A copy of the letter is available at www.phoenixfunds.com ).

Why make a change? The Internal Revenue Service requires investors to pay additional taxes on income from a mutual fund, regardless of whether it's a closed or open-end, when three conditions exist: the fund has current-year gains (current earnings and profits); it has accumulated losses from prior years; and the fund pays distributions exceeding those required by the IRS.

Because of the bear market, until recently, the two Zweig funds met the second and third conditions, but not the first. However, if the stock market keeps rebounding and the fund realizes capital gains instead of losses, shareholders in the future would have to pay full taxes, at ordinary-income tax rates, on the entire 10%.

Tax experts say the policy was unusual. Zweig shareholders "haven't had to pay taxes on excess distributions, because the fund didn't have the earnings.

Now Phoenix is changing the rules to prevent paying taxes in future, because they now expect substantial earnings and profits with a market recovery.

"It's to prevent paying excess taxes tomorrow, as opposed to curing a problem they've had in the past," says Robert Willens, tax expert at Lehman Brothers. "They'll gear their payments now to make sure they pay out no more than 98% of ordinary income, in order to avoid any excise tax," he adds.

Investors can draw important lessons from the Zweig funds, as there are plenty of others with high 9% and 10% payouts, according to Thomas Herzfeld Advisors, a closed-end fund investor. Among them are Alliance All-Market Advantage, Gabelli Blue Chip Value /zigman2/quotes/200765832/realtime GABBX +1.12% , Gabelli Equity Trust, Global Income, Liberty All-Star Equity /zigman2/quotes/201786389/composite USA +2.39% and All-Star Growth /zigman2/quotes/203240833/composite ASG +0.69% , Royce Value Trust /zigman2/quotes/205853816/composite RVT +1.81% , Source Capital /zigman2/quotes/207616906/composite SOR +0.91% , Spain Fund, Strategic Global Income and Tuxis.

Most important, these payouts aren't the same as "yield," although they might seem like the same thing. Says Phil Goldstein, a long-time closed-end fund investor: "Investors looking for high income will be attracted to a fund paying a 10% 'yield,' and may never realize their misperception."

That's because if the funds don't actually record stock-market gains, the payouts come out of principal and nibble away at net asset value. In short, these closed-end funds can end up paying investors back their own money (known as "return of capital"), slowly diminishing the fund's value over time. "It would be as if you put $1,000 in the bank, meanwhile reaping 10% interest every year, only to find out years later that the bank's been paying you back your own principal, and the money is mostly gone," Goldstein says.

The gimmick worked, and Zweig understood that on Wall Street, perception is reality: If enough people bought for a phantom "yield," that would help narrow the fund's discount.

Now that the gimmick is gone, Zweig Fund and Zweig Total Return actually did succumb to trading at a discount. And, Goldstein says, ironically, now may be the time to buy them.

The whole affair has the ring of the celebrated Broadway musical comedy, The Producers, in which has-been stage producer Max Bialystock learns from his accountant Leo Bloom that he could make more on a flop than on a hit. All they had to do was get a heap of money from gullible investors, stage a show so horrible that it closes right after it opens, then abscond with investors' dough.

Of course, unlike the fictional stage characters, Zweig and other funds offering "fixed payouts," didn't do anything illegal. But like the producers, they had an unexpected hit on their hands -- one that may be due for a final curtain call.

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