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Fund Spy

An Early Warning on Capital Gains Tax Distributions

Tread carefully at year-end when investing for a taxable account.

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In 2017, Hennessy Focus (HFCSX) paid out half a penny of capital gains per share on a net asset value of $87.76. In 2018, it paid out a huge $14.47 per share on a NAV of $67.71. This despite the fact that the fund returned 19.27% in 2016 and lost 10.47% in 2018. What happened?

Flows tell the story. The fund enjoyed inflows each year from 2013 through 2016, and even in 2017 they were a modest $148 million in outflows. But in 2018, outflows were $792 million from a base that started the year at $2.8 billion. For a fund whose asset base has bounced between $1.5 billion and $3 billion in recent years, that hit in 2018 was big. Inflows are a taxpayer’s friend because it means capital gains will be spread among more shareholders and the managers aren’t forced to sell anything they don’t want to. With outflows, though, a fund has to sell stocks unless they have a cash position larger than outflows. And after a long bull market, many stock funds are sitting on top of a big pile of profitable stock positions. The shift to passive from active means many are in outflows despite those gains. Once those profitable stock positions are sold, the fund makes a capital gains payout and fundholders get taxed. It’s a clumsy system because it doesn’t take into account fundholders’ actual gains in the fund.

Russel Kinnel does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.