Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The convergence of strong performance and investor redemptions means that numerous mutual funds will be making sizable mutual fund capital gains distributions later this year. Joining me to discuss that topic is Russ Kinnel. He is director of manager research for Morningstar.
Russ, thank you so much for being here.
Russ Kinnel: Happy to be here.
Benz: Russ, let's talk about how mutual funds work from the standpoint of capital gains. It might be unexpected for investors who own mutual funds in taxable accounts. They get these distributions, they might not be sure what to make of them. Let's talk about how mutual funds work when it comes to capital gains.
Kinnel: The tax rules for mutual funds and capital gains are a little archaic. Essentially, as they realize gains, they have to pay them out once a year. It's not necessarily how much you made in that fund with your investment. They have to distribute gains based on what they have realized. If they sell a number of stocks for a profit, then they sum that up against any losses they have realized and distribute that to shareholders evenly based on how many shares you have.
Benz: This is only an issue for you if you hold the fund in the taxable account. It's not going to be an issue if you've got it in an IRA or a 401(k) or something like that?
Kinnel: That's right. Don't worry about your 401(k) funds, your IRA, just your taxable account. Typically, these payouts are made mid-December, but it varies a little bit fund to fund.
Benz: Let's talk about why the past few years have tended to be bad for investors who own, in particular, many actively managed funds within their taxable accounts. What factors have been leading to funds distributing outsize capital gains distributions?
Kinnel: Well, we had our last real bear market in '08-'09. After that you initially had a lot of losses on the books for funds. For those first few years out of the gate you actually were able to write off most of your gains because you had matching losses. Now, they have worked through all of that. and you have got a really long-running bull market. That's part one.
Part two, as you mentioned earlier, outflows. A lot of active funds have outflows which is unusual when you are having these nice steady double-digit gains nearly every year in equities. But they have had outflows and that means now you got to pay out the gains to a smaller asset base. It means you are not having new money come in which would water down the gains. You have two things working against these funds that are in redemptions.
Benz: Let's talk about some of the funds that are anticipating sizable, meaningful payouts in terms of capital gains later this year. Are there any specific ones that you could highlight for us?
Kinnel: Sure. Columbia Acorn, another fund that's in significant outflows. They are expecting a double-digit payout. Some T. Rowe funds like T. Rowe Growth, T. Rowe New America Growth, around 11%. These are all estimates. They are not official, but pretty close. Vanguard, interestingly, Vanguard Explorer, which has not had particularly strong returns this year but is actually projected for an 11% payout. And again, the reason is significant redemptions.
On the flip side, there's some that have surprisingly low payouts. Vanguard International Growth is one of Vanguard's top-performing funds. It's up about 40% year to date, and they currently don't have it projected to pay out anything. And again, part of that story is, they are having significant inflows that waters it down. It means managers are not forced to go deep into their portfolio to sell holdings. They are not expected to do anything. Much less surprising is funds like Vanguard Total Stock Market, Vanguard 500 not projected to make a payout. It's very rare for indexes in general, especially a Vanguard index, to make a cap gains payout. They are very good at managing that. It certainly underscores some of the appeal of indexing.
Benz: Well, that was my next question. If I have taxable holdings and I want to try to manage this capital gains drag over time, it sounds like index funds and exchange-traded funds are a good place to start, at least in relation to my equity exposure?
Kinnel: Definitely. They have a lot of tax advantages. They have low turnover. Vanguard and others are pretty careful about managing those tax slots so that even though there is some selling even in an index fund, you can avoid capital gains. Index funds are definitely the go-to place for taxable accounts. Muni bond funds are another obvious one as they have tax advantages. You don't have to pay federal taxes on a state muni tax. That's another place. Beyond that, I think, occasionally I like low turnover, long-term-run active funds, I still think are a good idea, but I will be more selective in that area.
Benz: Last question for you Russ is, if someone has one of these capital gains payouts coming their way, investors might say, well, should I pre-emptively sell to avoid this distribution? What's your counsel there?
Kinnel: It certainly depends on your cost basis. If you've held it for a while, you probably aren't going to get much of an advantage selling unless it's the case that the fund has been making large distributions steadily. I think of like funds like Selected American that have really been making big payouts for a number of years because they have had a lot of redemptions after a lot of gains. Occasionally, it really just kind of depends on your situation. Funds are better at disclosing cost basis, so, it's a little easier to find that out and obviously have that conversation with your accountant. But generally, it's not worth it to sell in advance of that. There are occasions when it's worth checking out.
Benz: Maybe if you are planning to sell something anyway, or you wanted to lighten up on it in some fashion, it might make sense to sell pre-emptively as well?
Kinnel: That's right. If you are thinking about maybe selling in January or February, why not sell now, avoid that additional payout. And of course, another reason would be, if you've realized some losses elsewhere or you think you're going to realize a lot of gains next year, again you might want to smooth that out.
Benz: Good advice, Russ. Thank you so much for being here.
Kinnel: You're welcome.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.