What We're Not Thankful for: Big Capital Gains Distributions

Mutual fund capital gains distributions. They come unbidden, usually in early or mid-December. And they're one of the worst parts of owning mutual funds.

Funds might sell appreciated securities for a variety of reasons. Perhaps a stock hit management's sell target--not out of the question, given the ongoing strength in the market in 2014--or a new manager came aboard and wanted to change up the portfolio. Or perhaps management had to liquidate positions to pay off departing shareholders. 

Whatever the trigger, if funds have unloaded appreciated securities during the year, they have to distribute those capital gains to shareholders. If the shareholder owns the fund in a tax-deferred account, the distribution is a non-event from a tax standpoint. But if the investor owns the fund in a taxable account, he or she will owe capital gains taxes on the distribution. Those taxes will be due, unfortunately, regardless of whether those gains were reinvested right back into the portfolio and even if the investor didn't sell a single share.

Say, for example, an investor has a $100,000 stake in a mutual fund that makes a distribution equivalent to 12% of its net asset value. If the investor is in the 25% income tax bracket, he or she will owe 15% in capital gains on that $12,000 distribution, or $1,800. Of course, a distribution in excess of 10% of NAV doesn't come around every day. But in late 2014, five years into the current bull market, a number of funds, some of them prominent, are poised to pay out capital gains distributions in that ballpark. 

I took a look at capital gains estimates from a number of fund families. I've included links to each fund company's website; for each family, I've highlighted those funds whose distributions are around, or in excess of, 10% of NAV. (Note that these figures are all estimates; the actual percentage of NAV distributed will vary.) Many funds are set to pay out smaller distributions, however, and those two can translate into a significant tax hit for investors who hold sizable positions in taxable accounts. 

Vanguard
Vanguard displays funds' projected capital gains distributions both in dollar terms and as a percentage of the fund's net asset values. The firm released updated capital gains distribution estimates on Nov. 24, and a handful of funds appear poised to make sizable distributions. The biggest distributions will come from  Vanguard Explorer (VEXPX) (an anticipated distribution of 12.98% of NAV) and  Mid-Cap Growth (VMGRX) (11.97%). (Although the firm offers an index fund/ETF by the same name, the active fund is the one making the distribution.)  Vanguard Capital Value , whose 26% return over the past three years lands it in the large-blend category's top echelons, has an estimated distribution of 9.22% of NAV.

Fidelity
A handful of Fidelity funds are estimating capital gains distributions in excess of 10% of NAV, including  International Small Cap (FISMX) (13.14% of NAV), China Region (FHKCX) (12.25%), and  Capital Appreciation (FDCAX) (10.13%). Some of the firm's smaller Select funds are also anticipating capital gains distributions in excess of 10% of NAV, including Select Consumer Finance (FSVLX) (12.34% of NAV) and Select Environmental and Energy Portfolio (FSLEX) (12.02%).  Fidelity Contrafund (FCNTX), the firm's largest offering, has an estimated capital gains payout of just shy of 6% of its NAV. (Fidelity is one of the only large fund shops that doesn't depict its capital gains estimates as a percentage of NAV, so you'll need to whip out your calculator to determine an estimate in percentage terms.)

American Funds 
American Funds lists its funds' estimated capital gain distributions as a percentage of assets in ranges, to accentuate the fact that these are estimates rather than precise measurements. (The final percentage will vary based on the fund's net asset value at the time of distribution.) Among the funds that the firm is anticipating will make the highest distributions are  Growth Fund of America (AGTHX), with an anticipated long-term capital gain distribution between 9% and 12% of NAV;  Investment Company of America (AIVSX), with an estimated capital gain distribution between 8% and 11% of NAV; and  SMALLCAP World (SMCWX) (between 9% and 11% of NAV). Outflows from American Funds have slowed or stopped over the past year, which helps explain why these distributions aren't as high as some might have feared. 

PIMCO
Following the departure of longtime manager Bill Gross,  PIMCO Total Return (PTTAX) saw the fund world's largest outflows ever in a single month, $32.3 billion, in October 2014. Yet, because most of Total Return's gains come in the form of income, which is distributed to shareholders shortly after it is received by the fund, the fund is poised to pay out a minimal capital gain. The firm's biggest capital gains distributions will come from a handful of its StocksPLUS products:  StocksPLUS (PSPAX), StocksPLUS Absolute Return (PTOAX), and  StocksPLUS AR Short Strategy (PSSAX), all of which are estimating distributions of more than 15% of NAV. Morningstar has long recommended that investors hold PIMCO StocksPLUS in a tax-sheltered account because its income-centric strategy tends to lead to poor tax efficiency.

Franklin Templeton
As of Nov. 25, details on estimated capital gains distributions from various Franklin Templeton funds were listed as "pending."

T. Rowe Price
Among the big fund shops, T. Rowe had one of the longest lists of funds with estimated capital gains distributions in excess of 10% of NAV. They include Global Growth Stock (RPGEX) (11.3% of NAV), Global Technology (PRGTX) (21.98%), Health Sciences (PRHSX) (11.53%),  Latin America (PRLAX) (10.96%),  Mid-Cap Growth (RPMGX) (11.46%),  Mid-Cap Value (TRMCX) (12.07%),  New Era (PRNEX) (12.71%),  New America Growth (PRWAX) (12.78%),  New Horizons (PRNHX) (10.50%), and  Science and Technology (PRSCX) (14.91%). Morningstar director of manager research Russ Kinnel points out that being closed to new investors--as is the case with several funds on this list--will have the tendency to magnify capital gains distributions. New inflows into closed funds may not be substantial enough to match outflows, so management may have to sell shares to pay off departing shareholders. Those capital gains distributions, in turn, will need to be distributed across a smaller shareholder base.

JPMorgan
Five JPMorgan funds were estimating capital gains distributions at, or in excess of, 10% of their net asset values as of Nov. 25. They are International Research Enhanced Equity (16.24% of NAV), Intrepid Mid Cap (PECAX) (14.28% of NAV), Large Cap Value (OLVAX) (13.89% of NAV), Market Expansion Enhanced Index (10.51% of NAV), and Mid Cap Growth (OSGIX) (9.99% of NAV). 

Dimensional
Most DFA funds employ low-turnover, indexlike strategies, so it's not surprising that sizable capital gains distributions are few and far between in the firm's lineup. As of Sept. 30, 2014, just one DFA fund had an estimated capital gains distribution in excess of 10% of its NAV: DFA Enhanced Large Company (DFELX). 

Dodge & Cox
As of late November, none of the Dodge & Cox funds was anticipating a sizable capital gains distribution. 

Oakmark
Of the Oakmark funds, only  Oakmark Select (OAKLX) is scheduled to make a sizable capital gains distribution in 2014, amounting to roughly 11.5% of its NAV. 

What Now?
Unfortunately, there's not a lot that shareholders can do to avoid the blow. Pre-emptive selling before a capital gains distribution isn't usually wise, because doing so could trigger the shareholder's own tax bill on appreciation over his or her holding period. Instead, investors' best tack is to know what sorts of distributions are coming so that they can try to reduce the tax impact. They may be able to find losers elsewhere in their portfolio; selling those positions can offset the capital gain distributions. Additionally, they can make sure they're maximizing deductions to help offset their capital gains pain for that tax year. 

Finally, the large number of funds making capital gains distributions in 2014 accentuates the value of asset location--making sure that you're placing tax-efficient assets inside of your taxable accounts and reserving less-tax-friendly ones for your tax-sheltered wrappers. The recent round of distributions argues that if investors want to help protect against unwanted distributions, their best defense will be broad-market equity exchange-traded funds or index funds, which tend to distribute few, if any capital gains.

Note: This article has been corrected since original launch. The original article mistakenly referenced a 15% capital gains tax rate as applying to the 15% income tax bracket; the example has been corrected to indicate the 25% income tax bracket. We also corrected a reference to holding PIMCO StocksPLUS in a taxable account. We've long recommended the fund for tax-sheltered accounts, as the text now notes.

In addition, the original article stated that none of the Oakmark funds were planning to make a sizable capital gains distribution in 2014. Oakmark Select will, in fact, be making a sizable capital gains distribution, as indicated by the corrected information above.   

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