Christine Benz: Hi, I'm Christine Benz for Morningstar. Mutual funds typically make capital gains distributions in the fourth quarter of each year. Joining me to discuss what to expect in 2020 is Russ Kinnel. He's Morningstar's director of manager research.
Russ, thank you so much for being here.
Russ Kinnel: Glad to join you.
Benz: Let's talk about the mechanics of this. Why do funds make these capital gains distributions typically in the fourth quarter of each year?
Kinnel: Mutual funds are required by law to distribute virtually all of the net realized capital gains as well as income over the course of a year that they've realized, and the process is that they sum up their capital gains realized through the end of October and then typically distribute those in the last week or two in December.
Benz: Funds typically make estimates to shareholders. When do we start seeing those typically?
Kinnel: Usually, about a week or two into November, fund companies will post--on their websites--they will post estimates of the capital gains payout for all of their funds, and typically, those estimates are very close to what actually happens. So, they're pretty reliable.
Benz: If I own a fund in an IRA or a 401(k), this is kind of a nonevent for me from a tax standpoint, right?
Kinnel: Exactly. This only matters for taxable accounts.
Benz: If I own a fund in a taxable account and it is making a distribution, I will owe taxes on that distribution, correct?
Kinnel: That's right. Some people think at first, "Oh, well, they're paying me money, that's great." But no, actually, they're paying you money out of your own money and you're getting taxed on it when, from a tax standpoint, of course, you would rather have that compounding before paying the tax bill later on. So, it's not a good thing, though, obviously, if you've made really big returns, it's not the worst thing in the world.
Benz: Let's talk about 2020. It's kind of a funny year. We had a bear market earlier on. We still have a really big bifurcation in terms of performance with large growth performing really well and small value in its own little bear market. What should investors expect when it comes to capital gains distribution this year?
Kinnel: I think this is a really unusual year, and I expect as a result the capital gains story is going to be really all over the map, because as you noted, we had a bear market in February and March. So, obviously, if you sold anywhere around there, if your fund manager sold anywhere around there, they might realize some big losses. But since then the markets rebound. And on the other hand, growth is up about 20%; value is down about 12%. So, really, depending from fund to fund, from stock to stock, there's going to be a really big difference. And so, there's really a lot of potential outcomes for each individual investor depending on what's in their portfolio.
Benz: Do you have any thoughts about the categories or maybe specific funds where you might expect to see distributions? It seems like one thing that we know is when funds have had a lot of redemptions that that can sometimes trigger these distributions. Are there any areas that you're watching from that standpoint?
Kinnel: A lot of the areas that have been redeemed I think are value areas, which were hit hard enough that I wouldn't expect a big gain. But large growth has still been in outflows most of the last decade, and that's where the best gains are. So, where you have a fund there that's in outflows, I would certainly expect a significant payout. And really, active management in general has been for the most part in steady outflows.
Benz: Investors in a broad swath of actively managed funds could indeed see distributions. The question is, if a fund that I own in a taxable account has signaled that it's going to make a distribution, what are my options? What should I do in that instance?
Kinnel: Yeah. So, obviously, you want to prepare. One thing: If you just bought it, you could possibly sell it just because you haven't realized a gain. But that's only rare cases, I think. Generally, you don't want to sell. If you've owned it for a few years, you would just be having a different kind of capital gains event if you sold. So, that's no help. So, one, you can certainly prepare for it. The other thing, though--this year you may well have some losses you could realize to offset that. Obviously, you want to talk to your accountant about that. But if you have value stocks or value funds, you may hold something at a significant loss. And so, one nice thing about this year with the gains and losses is there are greater opportunities to harvest losses than in a normal year. Like, previous few years for the most part the market has just kind of steadily gone up and so there wasn't a lot in the red. But this year, we have a much more stark contrast between growth and value. So, look at your fund and stock holdings and see if there's some tax losses you can harvest.
Benz: You can do that netting of losses and gains. Let's talk about whether, within taxable accounts, does it generally make sense for investors to avoid active funds altogether and stick with index funds or exchange-traded funds?
Kinnel: Well, certainly, index funds and exchange-traded funds have a big advantage. Because they rarely distribute gains, it's very easy for index funds and ETFs to manage those gains. So, then when you factor in taxes, it makes it an even higher hurdle for an active fund. I would say, generally, passive funds and munis and others are probably the best way to go. I think if you want active, then certainly just be very choosy and say, "OK, maybe these are areas I think they're going to do particularly well in"--maybe an area that passive doesn't work so well and those are probably the best areas. But yeah, I think, passive is probably the right default in a taxable account.
Benz: Russ, important topic, especially this time of year. Thank you so much for being with us to discuss it.
Kinnel: You're welcome.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.