What to Watch for With Capital Gains Distributions

Christine Benz: Hi. I'm Christine Benz for Morningstar.com. As we move into the fourth quarter, many mutual fund investors begin thinking about mutual fund capital gains distributions. Joining me to provide a preview of what investors should keep an eye out for is Russ Kinnel. He is Morningstar's director of manager research.

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: Russ, let's just start with a question about why this happens--why mutual funds make these distributions--and then also let's talk about how they can affect investors who own these funds in their taxable accounts.

Kinnel: Tax laws require that mutual funds net out their capital gains, so they subtract their realized capital gains from the realized losses and distribute the difference evenly to all fundholders. Typically they do that at the end of the year. Usually it's based on the gains realized through the end of October. So, it's kind of an annual thing and in a long-running bull market it means just about every equity fund out there is distributing some capital gains most years.

Benz: We've seen particularly large distributions from some funds in the past few years. That owes in part to this long-running bull market that you just referenced, Russ. But let's talk about how fund flows can exacerbate this dynamic, where, if funds have been getting redemptions, they will make extra-large payouts in some cases.

Kinnel: That's right. So, because you spread out those capital gains among all the shareholders as of the distribution date in December, if that number of fundholders shrinks, then now you have more capital gains among fewer holders. So, you have a smaller base. If you have inflows, you have a bigger base, but then on top of that, of course, if you have a lot of outflows, you are forced to sell. So, a fund manager may be forced to sell even some of their winning positions and if that's being going on for a while, they may well have gone through their higher cost positions and of course you can't just simply sell the lower cost and let your fund become really lopsided. So, inevitably significant outflows lead to big capital gains in a bull market.

Benz: And we have seen particularly large outflows among many U.S. equity funds where investors appear to be trading into passive options. So, that's been another headwind in the mix, too. So, let's discuss other factors that can influence big payouts. Manager changes are one as well. Can you walk us through how that works from the standpoint of triggering distributions?

Kinnel: Yeah. So sometimes a manager change doesn't result in a really big change in the portfolio, but sometimes it does. The most dramatic is usually when there is a new subadvisor, because the subadvisor may well plug in their existing strategy portfolio, and therefore, they may really change over the portfolio. But even if it's simply a different manager within the same firm, they may have different holdings they like, they may be brought in to create some change--maybe the fund was floundering and the firm wants them to change the strategy. So, either way you can have some significant distributions with a new manager.

Benz: So funds begin making estimates of these distribution, say, start posting it them on their websites typically, but you attempted to kind of get ahead of that and look into fund data to try to figure out, "Well, which funds look like they could potentially be ready to make distributions?" What factors did you look at?

Kinnel: Yeah. It's in an exact science. But if you look at a few things usually you can get a ballpark idea. So outflows is a big one, of course. Returns--obviously you need to have some pretty good positive returns to have gains in the first place. Figures like tax-cost ratio, which is telling you about the past payouts, and similarly, if you have a rising trend of tax distributions. A particular red flag is if you have two a year--that means they are really trying to get ahead of things, they're really under the gun, they have a lot to distribute. So that's another red flag. And then, another one is potential capital gains exposure, which is, again, kind of a ballpark figure of just rough idea of how much gains a fund might have to realize if they sold the whole thing. So, obviously you're not going to see a fund pay out that whole amount, but the more embedded gains, the more likely it is to have at least some distribution.

Benz: So in the category of a fund that has been seeing redemptions and in turn looks like it could be poised to make at least some sort of a distribution this year, Davis New York Venture hit your screen.

Kinnel: Yeah, that's one that has been making two distributions a year. It's been in redemptions for a number of years. And so, I'm not necessarily expecting a massive, but I would expect probably something along the line of recent years, which is a sizable distribution.

Benz: OK. USAA International is another one. This one saw a manager change, and so you think that makes distribution likely.

Kinnel: That's right. USAA sold its fund lineup to Victory, and Victory fired the lead subadvisor on this fund, MFS, to bring it in-house. More profitable for Victory, but it also means a significant portfolio turnover and a likely capital gains payout.

Benz: So, a question here is, What should investors do if they're owning one of these funds in a taxable account? Should they try to sell ahead of the distribution? What sort of thought process should go on?

Kinnel: Yeah, well, it really depends what your cost basis is. Now fund companies are better at reporting that, so it shouldn't be too hard for you to see, "What's my embedded gain? How much have I got left?" Because if they've been distributing a lot already, maybe you've already paid most of your gains. And so selling wouldn't come with a big penalty. On the other hand, it might, and therefore it's kind of a wash. So, look at your own tax position, and you should be able to figure out what the best course is.

Benz: And I think a key takeaway is if I'm adding new assets to my taxable accounts ... really want to be deliberate about that process because some of these actively managed funds have not looked great from the standpoint of tax efficiency.

Kinnel: That's right. Asset location is a big deal, and part of that is deciding what should be in a taxable and what should be in a tax-sheltered. So, if you do choose equity funds for your taxable accounts, you want to think about, What are the funds that are less likely to do that? And, obviously, equity funds that are in redemptions are probably the worst ones to do. And then, on the other hand, passive funds or funds that are getting inflows are among the better ones to put in your taxable account.

Benz: Russ, important topic. Thank you so much for being here to discuss it with us.

Kinnel: You're welcome.

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