Funds Facing a Tax Overhang

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The year 2014 was a tough year from the standpoint of mutual fund capital gains taxes. Joining me to discuss this topic is Russ Kinnel--he is director of fund research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Good to be here.

Benz: Russ, let's start by talking about how mutual fund taxation works. In some respects, it's just like if you held any other security--an individual stock, say. So, if I sell the security and I had a gain in it over the period that I held it, I pay taxes on that. I also pay taxes on income distributions, just as would be the case if I owned an individual bond or whatever. But let's talk about these capital gains taxes. These are the ones that investors don't exert a lot of control over. Let's talk about how they work and also why the past few years haven't been so great from the standpoint of these big capital gains payouts.

Kinnel: The capital gains taxes are really the part in mutual funds where it's a little weird. It's unusual because funds are required to distribute their capital gains. So, if [their sales of stocks] have led to a profit, they distribute that capital gain to shareholders. And then shareholders, as of that capital gains date--usually it's one of the last few days of December--have to pay taxes on it the following April.

What's unusual, though, is it doesn't matter what your own tax position is. So, someone who bought the fund, say, Dec. 1, 2014 gets the same tax bill as someone who bought it 20 years ago and actually built up much more capital gains. So, it's a really weird quirk and, as you say, you don't really have much control over it. Once you are a shareholder on the date in which they pay that gain out, you're paying taxes on it.

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Benz: So, one of the funds that you highlighted in your recent issue of Morningstar FundInvestor, looking at the relationship between capital gains and recent developments, was Selected American (SLASX). Let's talk about how the past few years, in a few important respects, have been kind of a perfect storm for this fund. It did have a big capital gains payout last year; let's talk about some of the things going on behind the scenes that contributed to that big capital gains payout.

Kinnel: So, just about all stock funds have had a really nice seven-year run, and this fund is included in that. However, it had a few unique issues that made things a little worse. One was that longtime comanager Ken Feinberg left the firm around the beginning of the year, and Selected sold off two or three of his favorite names that didn't have that much support with the rest of the analysts. So, you had some long-held names being sold.

In addition, you had redemptions because, though the fund has gained ground over the last few years, it's lagged a bit. So, you had redemptions, and redemptions mean they've got to sell some holdings and then they're going to distribute that over, now, a smaller asset base. So, redemptions can be a real problem for capital gains.

Benz: So, if I'm looking at redemptions, how do I get my arms around that statistic? I can look at net assets maybe and compare them from one year to the next, but there are appreciations in the mix. How do I get my arms around whether there have been redemptions in the particular fund that I own?

Kinnel: Yes, you're right. You want to look at whether the fund's assets have actually grown by more than its appreciation or grown by significantly less. So, in recent years, with a fund that's had a lot of redemptions, maybe its assets have just shrunk a little because the portfolio has appreciated but you've got redemptions. So, in a generally rising market, if you see flat assets or slightly lower, that actually could mean pretty sizable redemptions.

Benz: So, I want to keep an eye on redemptions because it sounds like they have a role and they can potentially contribute to greater-than-average capital gains payouts. You also say to look at turnover and look at a statistic on our website called "potential capital gain exposure." Let's talk about these last two statistics. In particular, if I'm looking at turnover and I am looking at the potential capital gains exposure, what's a high number? And how do these two things work together? When should I be concerned that more capital gains payouts could be in the offing?

Kinnel: Turnover just tells you how much of a fund's portfolio is turned over. A typical equity fund might have, say, 70% turnover--though, it really runs a wide gamut. So naturally, the higher the turnover, the more likely it is that the manager is going to be realizing some gains in a portfolio that has appreciated.

Potential capital gains exposure essentially tells you what the embedded gains are. So, if capital gains is what they actually paid out, potential capital gains exposure is telling you that if they sold the entire thing--if the entire portfolio turned over--here is about what they'd have to pay out. They report that number once a year, and then Morningstar adjusts that on a monthly basis, depending on whether the fund went up or went down. So, it gives you a ballpark figure of how big a potential capital gain they are sitting on. I would say if the number is over 30%, then you are starting to get up there; if it's over 50% PCGE, then you are looking at a fund that's very likely to distribute some gains--especially if its turnover rate is also, say, over 20% or 30%.

Benz: So, the idea here is that these are statistics that might help me look forward. A statistic like tax-cost ratio is going to capture what's happened in the past; these two potentially together, maybe adding in redemption-related information, can help me think about being forward-looking.

Kinnel: That's right. Those numbers along with the redemptions give you a really good idea of what's coming down. Now, it's not precise enough that you can say, "A-ha, I'm going to get 12% payout." But it gives you a pretty good idea [of whether funds are] very likely to make some sizable distributions and maybe some others are not.

Benz: So, on a forward-looking basis, in your article, you highlighted some funds where they've maybe got high-ish turnover plus these fairly high potential capital gains. Let's talk about some of them. Selected American, we already talked about; but on a forward-looking basis, it looks like there could still be further distributions possibly for that one.

Kinnel: That's right. Even after last year, they've still got big built-up cap gains, and [although they don't have] very high turnover, it's high enough that I think they will continue to distribute cap gains. And because they've got redemptions, they are going to keep disturbing that to a smaller asset base.

Benz: Fidelity Contrafund (FCNTX) is another one that you looked at. Let's talk about the factors going on there.

Kinnel: This is a really good fund. We rate it Silver, so I wouldn't rush to sell it. But it's worth understanding where the fund is right now. It has pretty high built-up potential capital gains of more than 50% of assets, and you've got sizable turnover as well. Around half of the portfolio turns over each year. So, just naturally, I think it's very likely that you'll get some meaningful cap gains.

Now, if I've owned that fund for a while, I'm probably not going to sell because I'd still be getting a tax bill and Will Danoff is a very good manager. On the other hand, I might not be in a hurry to buy a fund like that and put it in my taxable-gains account.

Benz: Finally, Columbia Acorn (LACAX)--let's talk about that. Again, it looks like high PCGE as well as a fairly high turnover rate.

Kinnel: That's rights. So, Columbia Acorn is suffering from very large redemptions; almost half of the portfolio was redeemed in the trailing 12 months. So, they're going to have to distribute a lot of gains. They've still got big built-up potential cap gains exposure. So, it's really a difficult spot. When you have large redemptions, you really have no choice but to sell a lot of your holdings, and that means a big payout. This is a fund that we rate Neutral, in part, because we're even worried that the redemptions will hurt the returns as well, even on a pretax basis. So, there are some big red flags there, even though there are some good elements of strategy and manager there. It's definitely one I would be cautious about approaching today.

Benz: It sounds like in any case I need to pay attention to this idea of asset location. I want to make sure if I have some of these more-active funds with higher turnover rates, that I would probably want to hold them in some sort of tax-deferred account or tax-sheltered account; whereas I want to put more tax-efficient assets in my taxable accounts. I think all of these capital gains payouts raise the question of why bother with active funds in my taxable account. What do you say to that question?

Kinnel: I think it's a good point because index funds tend to be very tax-efficient. They have very low turnover, and many of the big index providers are very good at making sure that when they do realize some gains, they also realize some losses to offset that. So, you look at most index funds, and they have very low payout. So, I think that's maybe the go-to spot--in a taxable account. I wouldn't necessarily rule out actively managed funds in a taxable account; but for sure, if I'm building a portfolio on both a taxable and a tax-sheltered side, I'm much more inclined to put the active in the tax-sheltered and the passive on the taxable side.

Benz: Russ, such an important topic. Thank you so much for being here.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.

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