Solid Funds, But Far From Tax-Friendly

The year 2014 was a doozy for mutual fund capital gain distributions, and 2015 may be no better.

It's still early, of course. Mutual funds don't typically make their capital gains distributions until late in the fourth quarter of each year. Nor are market gains shaping up to be as strong as they were in 2014; at this rate, most equity investors would be lucky to end up in the black for 2015.

But big capital gains distributions are frequently a delayed reaction to strong investment performance, showing up a year or more after funds have posted a series of strong gains. And many active funds continue to lose assets at the expense of index funds and ETFs, and that has been one of the key factors contributing to mutual fund capital gains distributions in the recent past. Such redemptions often force managers to sell appreciated securities in an effort to raise cash to pay off departing shareholders. Those distributions, in turn, are distributed over the fund's shrunken base of shareholders, effectively magnifying the size of the distribution for a fund's remaining investors. Manager changes, whereby a new manager upends a long-standing portfolio of highly appreciated securities in favor of his own portfolio, are another frequent catalyst for outsized capital gains distributions.

Indeed, many otherwise-solid mutual funds have proved quite tax-unfriendly over the years, making sizable capital gains distributions. And judging from still-sizable potential capital gains exposures--which reflect the percentage of a portfolio that consists of capital gains that haven't yet been distributed or taxed--there could be more distributions in the offing. For that reason, I've recommended that investors skip actively managed funds for their taxable accounts and opt for index products instead.

For each fund, Morningstar.com features a suite of data to help investors assess the tax efficiency of holdings. Tax-cost ratios show what percentage of returns that investors in the highest tax bracket would have ceded to taxes over various trailing periods. Potential capital gains exposure provides a view of the gains embedded in a given portfolio and, therefore, depict what gains could be distributed if the securities are sold to meet redemptions or in the wake of a management change.

Once funds begin publishing estimates of their fourth-quarter capital gains distributions, we'll write about what's going on at the large fund shops. In the meantime, here's a view of Morningstar Medalist mutual funds that have high tax-cost ratios--which I arbitrarily defined as higher than 1.5% during the past three years--and potential capital gains exposures accounting for 25% or more of their assets. That doesn't mean that investors should avoid them, but they should think twice about holding them in their taxable accounts and, at a minimum, wait until after they've made any 2015 capital gains distributions before initiating sizable new positions.

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to view the screen's complete output or adjust it to their liking. Note that several funds on this list are closed to new investors; such funds often have above-average capital gains distributions because money can leave the fund and new money is often coming in at a much lower clip.

Here's a closer look at three of the still-open funds.

Category: Large Growth | Analyst Rating: Bronze

This fund made a whopping capital distribution in the waning days of 2014. The fund's assets have declined in recent years owing to underwhelming recent performance; its focus on high-quality growth stocks has left it out of step with the "risk on" mentality that has prevailed during most of the recent stock market recovery. The fund is also in the midst of succession planning in anticipation of the eventual retirement of longtime manager Ron Canakaris. While comanager Andrew Jung, who came aboard earlier this year, shares Canakaris' focus on reasonably priced growth stocks, it's possible that the transition could trigger still more distributions. Morningstar still likes the fund, but it's best situated within a tax-sheltered account.

Category: Large Blend | Analyst Rating: Bronze

This fund's story is a familiar one. It had a manager change in 2012, with Guy Pope taking over from noted value manager David Williams. While Pope and his team also employ a value-leaning strategy, they favor fallen growth stocks and decent companies dealing with transitory issues, not the restructuring plays that Williams looked for. Turnover under the new team's watch has also tended to be higher than it was during Williams' tenure. Moreover, the fund, like many on this list, has seen investors yank their shares. That convergence led to a large capital gains distribution in late 2014. Analyst Gretchen Rupp believes the fund is in good hands, as Pope and his team have compiled a strong record on

Category: Large Blend | Analyst Rating: Bronze

Both this fund and near-clone