Investors' Unwelcome Surprise

Susan Dziubinski: Hi, I'm Susan Dziubinski from Morningstar.com. As 2019 winds down, many investors have found themselves with an unwelcome surprise: capital gains payouts from their mutual funds. Joining me to discuss some lessons we can take away from this year's distributions is Christine Benz. She's our director of personal finance at Morningstar.

Christine, thank you for joining us today.

Christine Benz: Susan. It's great to be here.

Dziubinski: Now, first question. Let's step back a little bit and let's talk about why mutual funds make these distributions in the first place.

Benz: It's a vestige of mutual fund accounting, and it's an unfortunate side effect. So, for investors who own mutual funds in taxable accounts, they can pay taxes in one of two ways. One is if, at the year-end, when the funds total up the capital gains that they've realized during the year past, they must pay out those gains to shareholders. That's one way that you, as a fund shareholder, can be on the hook for capital gains. The other is that you owe capital gains on the spread between your purchase price, or your cost basis, and the price at which you sell it. So, it's an unfortunate side effect of investing in mutual funds. I think it partly explains why we've seen so much interest in index funds and exchange-traded funds because they tend to do a better job--because of their very low turnover--of limiting these capital gains distributions.

Dziubinski: And just this create a tax bill for everybody who receives one of these distributions?

Benz: It doesn't. So, the important thing to keep in mind is that most investors own mutual funds and tax-sheltered accounts of some kind. So, they own them in their IRAs or their 401(k)s. If you own a fund in such an account, and it makes a distribution and you reinvest that distribution, it shouldn't affect you at all. It shouldn't create any tax headaches for you. Where this comes into play is with your taxable holdings, where you are paying taxes on any dividends and capital gains that you receive on a year-to-year basis. So, this is only for people who own funds in a taxable account.

Dziubinski: Now, it seems like payouts have been on the rise during the past several years. What are the factors behind that?

Benz: Two of the biggies are that we have seen really strong market appreciation, right? Equity investors have enjoyed very strong gains. And the other part of it is that we have seen very big outflows from many actively managed mutual funds. Investors are doing the swap that I talked about where they're going from actively managed funds into index products. The net effect of that is when you sell your shares back to the fund company, oftentimes the manager needs to raise cash to pay all these people back. So, we've had funds having to sell appreciated securities in their portfolio to pay back shareholders who are leaving to go elsewhere.

Dziubinski: And how are distributions looking this year so far compared to years past?

Benz: I wish I could say definitively, because we don't at this time, although it's something we'd like to do maybe down the line, we don't aggregate all of the capital gains distributions together across every fund shop. What I can say, though, is that looking at my most recent data run, where I cull capital gains distributions from some of the largest firms. What I saw in comparing 2018 figures with 2019 is that things weren't looking quite so bad for many fund shops as they did last year. So, in 2018, even though it was a bad market, especially in the fourth quarter, 2018 we just had massive double-digit distributions as a percentage of funds' NAVs. When I look at the 2018 distributions, yes, there are some bad situations here and there, but it seems less widespread. So, it's not really a good news story, but maybe not quite as bad news as it was last year.

Dziubinski: Now, are there any particular types of funds or categories of funds where you're seeing higher distributions than maybe other types?

Benz: Yeah, definitely U.S. equity funds, the concentration seems to be there. And the reason why we're seeing more distributions there is simply because U.S. equity holdings have performed better than foreign-stock holdings.

With bonds, I should mention, Susan, they tend not to be big distributors of capital gains. The key reason is that as a bond investor, if you're in a bond fund, most of what you receive--most of your total return--consists of current income that comes to you year-in and year-out. So, U.S. equity is really the hotspot for distributions; large-cap and mid-cap growth categories have been seeing particularly large distributions, also in some of the very high-octane niche categories, so the technology sector funds, for example, we're seeing quite a few distributions come through there as well.

Dziubinski: Interesting. Now, on a fund family basis, one family, Invesco Oppenheimer, has seen reasonably sized distributions this year on some of its funds, and you say that isn't necessarily tied to redemptions. What's driving those?

Benz: Redemptions may certainly be in the mix as would strong market appreciation. But another factor affecting that fund shop, in particular, is that Invesco acquired OppenheimerFunds, and that resulted in a lot of manager changes. And that's another common catalyst for big capital gains distributions. When you have a manager take over oftentimes, he or she wants to remake the portfolio, and that can result in some selling that in turn can trigger some capital gains distributions. That's what's going on at a lot of the Invesco Oppenheimer funds that I surveyed. And that does appear to be one of the hardest-hit fund shops from the standpoint of big distributions this season.

Dziubinski: Right. So if I'm an investor, and I know I'm going to be getting whacked with a sizable capital gains distribution in a taxable account, what are some things I should be thinking about or doing?

Benz: Well, one thing that I think sometimes occurs to investors is, well, what if I just get out of this fund ahead of its mid-December distribution or whenever it's making its payout. Usually, you want to keep in mind those two sets of taxes. So, yes, there might be the capital gains distribution coming from the fund, but you also want to think about what sort of capital gains you might trigger with your own sale. So, again, as I mentioned, originally, you will owe taxes on that differential between your cost basis and your eventual sale price. The good news is--if there's any good news in this--is that if you have one of these, what I call a serial capital gains distributor, so you've got the fund where it's been making distributions year after year after year. Take a look at your cost basis, and you should be able to get that from your fund company because fund companies track that for us now. Find your cost basis and compare it to the fund's current NAV, if those two numbers aren't that far apart, it may be that you have effectively--because you've been receiving these distributions and paying taxes on them--you've been effectively prepaying your distribution. So, giving your portfolio a tax-efficient makeover, getting into something that is more tax-efficient, may not be as costly as you think.

Another strategy, Susan, that I think people should consider at a minimum is they should consider not reinvesting that distribution and maybe taking it and deploying it into something else in their portfolio that they wanted to add to anyway. So, a common situation today is investors have heavily weighted equity positions, they know they should get some assets over into the safe stuff. If a fund that you want to stay in is making a distribution, steer that distribution to an investment that you'd rather top-up, and the tax effects will be effectively the same. So, that's something to look into as well. Here, though, I would say it's a great spot to stop and get some tax advice if you're not super comfortable in this whole matter of, say, calculating your cost basis, check with a tax advisor to give you some guidance on what's the best course of action.

Dziubinski: That sounds like some good advice. Christine, thank you so much for your time today.

Benz: Thank you, Susan.

Dziubinski: For Morningstar, I'm Susan Dziubinski. Thanks for tuning in.