Halloween is a Scary Time for Active Mutual Fund Investors
Halloween is often a scary time to own active mutual funds in taxable accounts. It means that capital gains distributions are just around the corner. Russell Investments predicts that “2020 could be a record year for taxable distributions tied to capital gains.” Most mutual funds ended their fiscal year on September 30th. Most will distribute capital gains to shareholders sometime in November or December.
The reason that 2020 may be a record year for capital gains distributions is the massive selling that went on in the first half of the year due to coronavirus pandemic, coupled with the dramatic increases in stock prices accumulated since 2009. “The volatile first quarter of 2020 and generally strong equity markets since 2009 are coming together to create the (im)perfect storm of tax headwinds across client accounts,” according to Russell.
As shown in the bar graph below, in past years the size of capital gains distributions has been clearly affected by investor outflows. The first half of 2020 saw a tsunami of selling, forcing mutual fund portfolio managers to sell positions in order to raise cash. The tax bill will soon be due.
* Russell 3000® Index. Sources: Morningstar Direct, Russell Index. Data shown is historical and not an indicator of future results. Indexes are not managed and may not be invested in directly. Original graphic found here.
Forewarned is Forearmed
Most mutual funds make estimated capital gains distributions available to shareholders in October, so now is the time to click on your mutual fund company’s website or give them a call to find out what your tax bill may be. There may something you can do to mitigate the tax bill: “tax-loss selling.” This involves selling positions at a loss. Be aware that you cannot buy the same securities back within 30 days or the transaction will be considered a “wash sale” and you won’t be able to take the loss at tax time. Given the dramatic rise in the stock market since the nadir in March of this year, there are not very many positions that are likely to be priced below their original cost or “tax basis,” but it’s worth checking.
Sometimes, receiving a large and unexpected capital gains distribution can cause an investor to reconsider the wisdom of owning an active mutual fund. Perhaps it is time for you to consider some alternatives.
Index Funds are More Tax-Efficient Than Active Funds
Portfolio turnover (buying and selling securities) within a fund is what causes it to realize gains, which must then be passed on to fund shareholders at the end of the year. Year-in and year-out, actively managed funds have much higher levels of turnover than passively managed funds (index funds). Although even an index fund will have to sell securities in the event of a substantial amount of shareholder redemptions (such as occurred in 1H 2020), in the normal course of operations, active management itself tends to drive turnover, whereas, index fund turnover typically occurs only to the extent that there are changes in the index constituents (new stocks being added and old stocks being deleted). Actively managed funds often have turnover rates in excess of 100% whereas indexes (and consequently index funds) typically have turnover of less than 10%.
The distribution of capital gains is only one consideration when making the choice between active and passive funds, but it is one that investors often overlook. Most investors focus more on the difference in expense ratios (index funds charge much less) and in the tendency of actively managed funds to under-perform index funds, on average. Tax efficiency is just one more reason that investors increasingly prefer passive funds to active funds.
ETFs are More Tax-Efficient Than Mutual Funds
Most ETFs are passively managed index funds with low turnover. But even compared to an index mutual fund using the exact same underlying index, an ETF will be more tax efficient. As explained by ETF.com, ETFs are inherently more tax efficient than mutual funds…
…thanks to the magic of how new ETF shares are created and redeemed. When a mutual fund investor asks for her money back, the mutual fund must sell securities to raise cash to meet that redemption. But when an individual investor wants to sell an ETF, he simply sells it to another investor like a stock. No muss, no fuss, no capital gains transaction for the ETF.
What happens when the selling is so great that the market price starts to go noticeably below NAV, or the “net asset value” of the underlying portfolio of securities? In such cases, an “authorized participant” (AP)—usually a large bank—steps in to accommodate the selling pressure by “redeeming” ETF shares. ETF.com continues:
When APs redeems shares, the ETF issuer doesn’t typically rush out to sell stocks to pay the AP in cash. Rather, the issuer simply pays the AP “in kind”—delivering the underlying holdings of the ETF itself. No sale means no capital gains.
The ETF issuer can even pick and choose which shares to give to the AP—meaning the issuer can hand off the shares with the lowest possible tax basis. This leaves the ETF issuer with only shares purchased at or even above the current market price, thus reducing the fund’s tax burden and ultimately resulting in higher after-tax returns for investors.
The system doesn’t work so smoothly for all ETFs. Fixed-income ETFs, which have more turnover and often have cash-based creations and redemptions, are less tax efficient than their equity brethren.
But all else equal, ETFs win hands-down, with two decades of history showing they have the best tax efficiency of any fund structure in the business.
How much difference does this make in investors? ETF.com cites the example of emerging markets equity mutual funds. “The average emerging markets equity mutual funds paid out 6.46 percent of their net asset value (NAV) in capital gains to shareholders, every year. The average emerging market ETF paid out 0.01 percent of its NAV as capital gains over the same stretch.
At a capital gains tax rate of 20%, that amounts an average tax drag on performance of 1.3% per year. Ouch!
What You Can Do to Limit Your Tax Hit
- Harvest capital losses in taxable accounts and use them to offset capital gains.
- If you are thinking of investing in an active mutual fund in a taxable account, at least wait until it has distributed capital gains for 2020. Better yet, consider a more tax-efficient alternative investment such as an ETF.
- If you are reinvesting dividends from an active mutual fund held in a taxable account, change your instructions to receive dividends in cash and invest the cash in a more tax-efficient fund.
- Sell the active mutual fund out of your taxable account, wait at least 30 days (to avoid a wash sale), then buy it back inside a tax-deferred account such as an IRA.
- Make sure that your least tax-efficient investments are in your IRAs and your most efficient investments are in your taxable accounts.
This content is developed from sources believed to be providing accurate information, and provided by Sapient Investments. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.