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Watch Out for the Tax Bill on These Funds

High outflows, a low cash stake, and accumulated capital gains may create a perfect storm.

Laura Lallos, 07/24/2014

This article was published in the July 2014 issue of Morningstar FundInvestor.Download a complimentary copy of FundInvestor here.

Many stock funds in the Morningstar 500 are currently sitting on substantial capital gains. Nearly 150 of them had potential capital gains exposure of 33% or more at the end of June; put differently, this represents at least a third of their asset bases. 

That's not a bad thing, per se: Those gains won't necessarily be realized and distributed to shareholders. In fact, high potential capital gains exposure generally indicates that a fund has both earned a nice return and been tax-effi­cient in the process, usually by keeping turnover low and sometimes by intentionally taking taxes into account when trading. Vanguard Tax-Managed Capital AppreciationVTCLX, which aims to mini­mize regular taxable distributions, has a potential capital gains exposure of 51%. (In fact, it has been at least a decade since it made a capital gains distribution.)

Nevertheless, you wouldn't want to buy into a fund and then get hit with a distribution of gains you weren't around to enjoy. While a low-turnover fund isn't likely to suddenly sell off a significant portion of its port­folio, sometimes a manager's hand is forced by redemptions to raise cash. And many stock funds have been in steady net redemptions over the past year.

Triple Threat 
Westport Select Cap WPSRX might be a perfect storm. It has potential capital gains exposure of 73%, the highest in the 500. On top of that, shareholders have been selling out; the fund has had nearly $120 million in net outflows over the past 12 months, a significant chunk of its asset base, which is now below $400 million. Finally, the fund had almost no cash reserves as of the end of June.

The pent-up gains at Royce Low Priced Stock RYLPX aren't as dramatically high at 37%, but it has seen extraordinary outflows of $1.4 billion over the past 12 months, cutting its total asset base to $1 billion. It, too, has little cash on hand to meet future redemptions. Similarly, Wasatch Ultra Growth WAMCX, with potential capital gains exposure of 45% and almost no cash, has had net outflows of nearly $60 million over the past year, bringing assets down to around $110 million.

These are extreme but not isolated examples. There are several other funds with a particularly potent combination of potential capital gains exposure greater than 40%, almost no cash, and significant outflows over the past year that have persisted in recent months. They include Columbia Acorn USA AUSAX, Columbia Acorn Select ACTWXAriel ARGFXFidelity Growth Company FDGRXFidelity Small Cap Value FCPVX, and Royce Premier RYPRX.

Unlikely but Not Impossible 
A fund with high potential capital gains exposure that also has a low-turnover strategy and net inflows is less likely to make significant distributions. Vanguard Tax-Managed Capital Appreciation falls into that camp. Those funds with cash at the ready to meet redemptions may also be able to spare shareholders a distribution.

A high cash stake is no guarantee that a fund won't be selling stocks. Cash-heavy Longleaf Partners Small-Cap LLSCX distributed about 15% of its net asset value in 2013, because its managers were selling holdings deemed too pricey. While shareholders may have been unpleasantly surprised, the move made sense given Longleaf's pessimistic view of valuations. Unless a strategy is specifically designed to minimize taxes, sizable distributions are always a possibility.

A previous version of this article incorrectly listed some fund examples; they have been removed.


Laura Lallos is a former Morningstar analyst and editor, and a frequent contributor to Morningstar Advisor magazine.

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