Peeling the Onion

"Peeling the Onion" on Mutual Funds Capital Gains Tax - Brings Tears to the Eyes!

Wall Street rarely (OK never) sends “a warning memo” in advance of a pending negative market event to investors. Imagine the erosion of portfolio values that would have been avoided in the late 2000’s if they did! However, in the 4th Quarter of every year – mutual fund companies do just that – they post their estimated capital gains distributions for each fund. Furthermore, the companies tell investors well in advance the exact date they will be distributing them.


This is incredibly valuable investor information as it should influence some rudimentary annual tax planning for mutual fund shareholders. At Piedmont Wealth Advisory, we are believers in a blend of active and passive portfolio management – and have vetted out several mutual funds to include in portfolios – however “caveat emptor” – when it comes to annual taxable distributions, not all funds are created equal!

First, we will “peel and sauté the onion” a bit on how mutual funds operate (looks like we will work in a little cooking theme this week). By design, mutual funds are required to distribute 90% of realized dividends and capital gains to shareholders on an annual basis. This distribution is a blend of “realized” capital gains and cumulative dividend activity occurring over the past year inside the fund. Additionally, all shareholders as of the “record date” (generally in December a few days before distribution is paid) receive the exact same distribution (shown in terms of a “%” of their total fund value) regardless of how long you have owned the fund during the year. If a fund is priced at $10 a share and pays out a 20% distribution – all shareholders will receive $2 of taxable distribution per share. In Non-IRA accounts – this is an “involuntary” taxable event. By “Involuntary”, the tax is levied regardless if the shareholder has sold any shares during the year or not or if they have held the fund for a month or the entire year. (Note – there is no tax due when annual distributions occur within a retirement account).

“Doug – haven’t you always been a believer in the power of Equity Dividends?” Absolutely YES!

Its time now for the next layer of the mutual fund onion........When a mutual fund pays out their annual distributions – it is a blend of realized Capital Gains and Dividends earned - (with qualified dividends generally taxed at 15% and non-qualified dividends generally taxed as ordinary income). Investors expect to pay annual taxes on Dividends earned outside of a retirement account (that is the goal after all) – but NO investor actively seeks an opportunity to pay taxes resulting from the activities of other investors. Ok - it’s now time to sauté the next layer of the mutual fund onion – (for you chefs out there – the onions are now “sweating” so it’s now time to throw in the chopped garlic)!

Of interest to fund investors, these annual taxes can erode investment performance significantly. Leading industry experts estimate that the long-term average annual tax cost for actively managed stock mutual funds exceeds 1% - with that number higher for bond funds! Coupled with internal expenses, this creates a difficult annual return experience for investors.

What causes funds to generate annual Capital Gains?

At the most basic level actively managed mutual funds generate capital gains when they sell holdings for more than they paid for them (another investor goal BTW!). In addition to high portfolio turnover (high level of buying and selling during a year), another major factor that influences annual fund Capital Gains generation – Fund OUTFLOWS! When other investors decide to sell their positions in a mutual fund and pull their money out – this is an “outflow”! To meet an “outflow”, if fund managers are not holding large cash positions, they must liquidate existing holdings inside their funds to meet this investor demand. When funds have liquidations, and selling occurs on the heels of an extended bull market there are capital gains to distribute!

Are Outflows a significant concern – if so where is the money going?

In a word – YES, outflows from Mutual funds are and will continue to be a big mutual fund investor concern. Where is most of it going? Exchange Traded Funds (ETF’s). According to generally accepted estimates, this year US exchange listed ETF’s have attracted over $300 Billion of new money thru the end of September in 2017 - $300 Billion in 9 months…..(pause for second to let that sink in)! As a comparison, during all of 2016 ETF’s attracted roughly $250 Billion in new assets. Where is this coming from? – several sources are feeling the impact including actively managed mutual funds. Some in the investment community view ETF’s as a passing fad however when large institutions such as Harvard University’s $37 Billion endowment is actively increasing their exposure to ETF’s, I like the chances of this “fad” enjoying an ongoing multi decade run! Why the move to ETF’s? This will be a theme for another “Piedmont Vine”, but among the leading influencers for the shift are extremely lower fees, far lower likelihood of “involuntary capital gains tax”, and exceptional long-term performance!

If you have any questions regarding the upcoming potential financial impact from capital gains distributions from your mutual funds, please make a point of reaching out to your advisor (or send us a note and we will gladly do this important work for you…and them!).