Mutual fund investors have not had much good news lately, but there is a glimmer of sunshine: Some of their big losses of the past two years could be a big benefit in the long run.

The losses can be used by mutual funds to offset capital gains -- not just this year but for eight years. That means that when the market finally turns around, fund gains are likely to be sheltered from taxes for some time.

"Mutual funds will be much more tax efficient over the next five years than they were the last five years," said Don Phillips, managing director at Morningstar Inc. "This is a huge opportunity for investors."

But picking funds based on their losses is dangerous, fund analysts warned. "Some of these funds are so bad, they'll never recoup," said Sheldon Jacobs, editor of The No-Load Fund Investor in Ardsley, N.Y. "You need funds that will recoup their losses."

Some funds that have been the most successful at accumulating losses the past two years have been technology and communications funds. They accounted for nine of the 15 U.S. equity funds with the biggest tax-loss positions at the end of the third quarter. Among these funds are Berkshire Focus, ProFunds UltraOTC and Firsthand Communications. In many cases, their losses represent hundreds, if not thousands of percent of their current assets, according to Morningstar.

"A lot of these funds are extremely aggressive; some are not very good," said Scott Cooley, a senior analyst at Morningstar, speaking of the 100 funds with the largest tax-loss positions. "Many take on more risk than most people are willing to tolerate."

Still, the selloff in the market has been so widespread that even funds with good long-term records have lost significant amounts. Among such funds are Legg Mason Value Trust, Transamerica Growth Opportunities and Fidelity Independence.

"The story now is buying funds with tax losses that won't pay capital gains for years," Jacobs said. "You have to be judicious in picking funds."

The situation is a reversal from the late-1990s, when funds were sitting on gains earned in the long bull market. Investors with taxable accounts who bought into funds late in a year often risked receiving distributions before their own shares had a chance to appreciate.

The federal tax code requires mutual funds to pay at least 98 percent of their income and capital gains to shareholders every year. Many funds make those distributions in the fourth quarter.

This year, however, many investors are buying into losses. They can hardly help it. Of the 3,308 domestic equity funds with capital gains data tracked by Morningstar, 88 percent, or 2,926, have negative capital gains exposure.

That means that if these funds' investments were liquidated, they would generate no tax liabilities, because their investments are worth less than what the funds paid for them.

Most mutual funds will not be liquidating their portfolios, but the losses can be used by their portfolio managers to offset future gains.

"People who buy into funds now get a built-in advantage," said Chris Wheaton, a partner and portfolio manager at Litman/Gregory Asset Management in Orinda. "They can invest in funds with carry-over losses that were incurred by other fund shareholders."

Unlike a fund's capital gains, which must be distributed yearly to shareholders, a fund's capital losses stay with the fund, and while they can offset the fund's capital gains, they cannot be used by investors to offset gains on their own tax returns. Capital gains and losses are disclosed in a fund's annual and semiannual reports.

Not all capital gains and losses can be claimed for tax purposes. For example, under the "wash sale" rule, the IRS does not allow a loss deduction when shares are sold and then bought back within 30 days.

The average domestic equity fund now has negative capital gains exposure equal to 62.5 percent of assets, according to Morningstar. "We have seen negative capital gains exposure in pockets such as with emerging-market funds," Phillips said. "But we have never seen this before on such a broad scale."

Essentially, the average fund could rise more than 62 percent in value before it would have to pay a capital gains distribution, Cooley said. That assumes that assets remain constant; if assets rise, the losses would be diluted.

Conversely, if assets fall, the losses would become a bigger factor, as has happened with many technology and telecommunication funds. Large flows of money into and then out of these funds, and significant losses in technology and telecommunications stocks have led to millions of dollars in capital losses. As investors have fled these funds, those losses have become a bigger proportion of remaining assets.

ProFunds UltraOTC, for example, had $1.6 billion in capital losses, of which $884.6 million was carried forward for tax purposes, the fund's 2001 annual report said. Morningstar estimates that the fund's current losses represent more than 1,000 percent of its $109.5 million in assets.

"We are leveraged," said Michael Sapir, chairman of ProFunds in Bethesda, Md. "Our objective is to double the return of the Nasdaq 100 index. To the extent the index goes up in a sustained fashion in the future, these losses could benefit shareholders of the fund."

Firsthand Communications had $466 million in losses on its books as of the end of June. Morningstar estimates that the fund's current losses also represent more than 1,000 percent of its $44.8 million in assets.

"It's an advantage we weren't expecting, and we're not necessarily thrilled how we got it," said Kevin Landis, chief investment officer of Firsthand Funds, "but we have it now, and we will use it the best way we can." Firsthand Funds is seeking shareholder approval for merging Firsthand Communications into Firsthand Technology Value, which had $2.96 billion in losses on its books as of June 30.

Some of these losses are so large that they are not likely to get used up. "Some managers don't think they can generate gains to offset these losses," Phillips said. "Some losses will expire unused."

Rather than picking funds on the basis of their tax losses, a better approach is to find funds with good track records, then analyze their tax position, fund analysts said.

Among Jacobs' picks is Legg Mason Value Trust. While the fund was down 28.5 percent this year through September, it ranks among the top 7 percent of large blend funds over the past five years with an average annual return of 1.7 percent. Bill Miller, the fund's manager, has racked up a record in which he has beaten the Standard & Poor's 500-stock index in each of the past 11 calendar years.

The fund had realized and unrealized losses of $1.2 billion on its books, according to its March 2002 annual report. Those losses represent 13 percent of its current $9.1 billion in assets. While that percentage pales in comparison with tech funds, the losses are useful.

"In our opinion, $1.2 billion of losses shelters a lot of gains going forward," said Nancy Dennin, assistant portfolio manager of the fund. "It will be some time before many shareholders receive a capital gain," she said.

Transamerica Growth Opportunities also has a good long-term record and substantial tax losses. The fund's average annual return over the past five years is 7.9 percent, which puts the fund in the top 3 percent of its mid-cap growth peers. This year, the fund is down more than 20 percent. The fund had $61 million in losses on its books on $90 million in assets as of last December.

"Clearly, there are a lot of tax losses available should we take capital gains," said Christopher Bonavico, the fund's portfolio manager. "But, obviously, the most important thing is to compound our assets."

He said he would not use the losses "just for tax reasons."