When we filed our tax returns or extensions by July 15 — three months later than usual — we went through the annual exercise of gathering all the necessary forms and receipts, including the capital gain distributions reported by our mutual funds on the 1099-DIV.
Realization of capital gains is a natural part of the investment process. After an initial investment, the goal is to sell that investment in the future at a gain, which the US government will tax. But things get a little more complicated when you consider a mutual fund investment. Let's look at two scenarios where a mutual fund investor may end up paying more in capital gains taxes than expected.
Inheriting a mutual fund's cost basis
After buying a mutual fund unit at a certain net asset value (NAV) and then selling it at a higher NAV, an investor pays capital gains tax. But the investor is also exposed to the decisions of the fund manager. If they sell a security at a gain, the investor receives what's called a distributed capital gain and pays the tax on that sale. Of course, it's the portfolio manager's job to buy stocks and sell them at a gain. But it's important to remember that computed gains are based on the fund's cost basis — not the investor's.
Let's say an investor buys units of a mutual fund. A few days later the manager decides to sell the fund's position in a wildly successful mega-cap technology company. While the investor enjoys a few days of gains, the fund's position in the company is years old, with a lower cost basis and a much larger associated gain. When the manager sells the position, the gains it realized over the years are distributed to the investor, who effectively inherits the cost basis of the underlying holdings in the fund.
Before buying into a fund, we think it's a good idea to assess the amount of capital gains the fund is sitting on. Morningstar conveniently provides a measure called potential capital gain exposure (PCGE) for this very purpose.1 For example, a fund whose assets have appreciated by 40% has a PCGE of 40%.
Paying for another investor's sale
Sometimes the pursuit of additional return — the principle of buying low and selling high — motivates a fund manager to sell securities. But sometimes the liquidity needs of other investors in the fund drive those sales. When a mutual fund investor decides to redeem their shares for cash, the portfolio manager may be forced to sell investments to meet that redemption. This sale may trigger a capital gain, which is distributed to the remaining shareholders.
Similarly, as some investors reduce their exposure to active management in mutual funds in favor of index exposure through ETFs and direct indexing solutions, the redemption of mutual fund shares could trigger large capital gain distributions for remaining shareholders.
Capital gain distributions in 2019 and onward
According to the Investment Company Institute, capital gain distributions from equity mutual funds in 2019 totaled $318 billion — lower than in 2018 but still meaningfully large for the investors that receive them. Notice in the graph below that gain distributions were relatively light in the years following the global financial crisis because of losses from 2008 to carry forward. Funds were able to offset realized gains with loss carryforwards, suppressing the distribution of taxable capital gains to investors.
That welcome vacation from gain distributions ended in 2013, when the funds used up their loss carryforwards and resumed the distribution of capital gains. Capital gain distributions since then have been strong, at two to four times the levels seen in 2008.
Notice as well that capital gain distributions hit a peak in 2018, a year in which the S&P 500 Index declined over 6%. Yet mutual funds distributed the highest aggregated capital gains ever recorded, and capital gains taxes were proportionately high — truly adding insult to the injury of the declining market.
Capital gain distribution by equity funds ($MM)
Source: Investment Company Institute, 2020 Investment Company Factbook, May 6, 2020. For illustrative purposes only. Not a recommendation to buy or sell any security.
This may prove to be a year of mixed results for mutual fund holders. Since dropping in February and March at the onset of the COVID-19 pandemic, the equity market has staged a huge recovery, even showing a positive year-to-date return on June 8. Market volatility remains high, with daily gains and losses of one to two percentage points. In times of high volatility and market weakness, outflows from funds tend to be heavy. Combined with high amounts of unrealized gains, these outflows could result in another year of large capital gain distributions.
What's a mutual fund investor to do?
Capital gain distributions are an inevitable part of the mutual fund experience. The size and timing of these distributions may come as a surprise depending on the fund's history and the liquidity needs of other shareholders — factors largely out of an individual investor's control. However, we believe there are ways to mitigate and limit exposure to these distributions and their associated taxes:
- Consider replacing mutual fund holdings with a potentially more tax-efficient separately managed account (SMA). This seeks to provide a similar return, but instead of distributing taxable capital gains, it can produce tax losses, which can be used to offset gains and lower the investor's tax bill.
- Consider combining mutual fund holdings with a customized SMA solution. Many funds provide unique exposures to specific asset classes or access to superior security selection. This way, an investor could retain those funds and complement them with an SMA portfolio, which can provide valuable tax losses to offset the gains distributed by the fund.
Bottom line: It was quite a surprise to have tax day in the middle of the summer this year. Many investors may be even more surprised with the capital gain distributions from their mutual fund holdings and the resulting tax bill. Investing in more customized separately managed accounts — either to replace or complement mutual funds — may allow greater flexibility, control and predictability when it comes to capital gain management.