Investing Insights: Year in Funds, Tax Reporting Missteps

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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The year 2018 ended on a sour note, and most mutual fund categories ended the year in the red. Joining me to provide a recap of the past year's worth of mutual fund performance is Russ Kinnel. He is director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: Russ, it was a disappointing year, and it really didn't matter whether you were a bond investor or a stock investor. Can you discuss some of the forces driving down both stock and bond markets last year?

Kinnel: You are right. There was really a red ink across the board, though bond losses much less so than equities. But I think you had a number of factors going in. You had things like trade tensions, growing deficit for the U.S. but also, really just underscoring all that I think is that we have had a tremendous bull market. Equity valuations were stretched and so probably more vulnerable than usual for a correction. You can only go so long before you have a correction. I think all of that was in play. And of course, it's easy with hindsight, but even now I don't think we know exactly why the market sold off the way it did.

Benz: Right. And it's not necessarily done either. In the beginning days here of 2019 we are also seeing some volatility.

Kinnel: That's right. I think that's the real concern is, when you consider how much the market has gone up in the last eight years, if all we have is that 20% haircut, it's really not a big deal. But the real concern is, that obviously could just be the first leg. We tend to overdo it both on the upside and the downside. There's no reason we couldn't have a real bear market this year.

Benz: Really good point. Let's take a look at some of the hardest hit categories as you survey the fund universe, some pockets of real weakness. Energy sector, China was hard hit. What were some of the other areas?

Kinnel: Also, we had foreign small-cap funds were hit pretty hard, too. In that case, it was really the case of a rising dollar. Most foreign equity funds are not hedged. But also, worries about Brexit and other trade issues hurt them. That's also part of what hurt China. China was hurt by trade tensions with the U.S., declining property prices in China, and just some general worries about growth. Energy, of course, pretty straightforward: Oil declines, energy stocks go down.

Benz: Let's talk about what we saw on the domestic equity side. You noted that there was a huge bifurcation between large-growth stocks and small-cap value stocks. That's interesting because really the large-growth stocks or certainly the technology stocks have been kind of at the epicenter of the recent volatility. But the long-run pattern is that large-growth stocks have performed very, very well and indeed did in 2018.

Kinnel: That's right. I've been watching large-growth versus small-value and it's a very long run that large-growth has outperformed small-value to the point where now if you look at the five-year returns, large-growth returns are about 3 or 4 times greater than small-value. And interestingly, as you say, even on the downside, large-growth lost a lot less than small-value. Part of that was because we had a tremendous FAANGs rally to start the year and then a lot of those big tech stocks sold off sharply, but they still were up or not down that much. You end the year with a small loss for large-growth and pretty big loss for small-value. Yet again, we have that tremendous difference in large-growth and small-value.

Benz: A question is, if people are looking at their portfolios, potentially doing some repositioning, is small-value potentially a place to take a look at?

Kinnel: I think so. I think generally rebalancing is valuable for that discipline because it forces you to invest in the areas that have gone down and the areas that may well be the cheapest. So, yeah, I think it's an attractive area. Obviously, it's been that way for a number of years. It's not like we can say, aha, now it's going to turn around today. It doesn't work that way.

Benz: I suppose another risk is that some of those small-value stocks are pretty cyclical and so, if we are headed into some sort of a broader economic downturn, they could feel some pain.

Kinnel: That's right. And it's no accident that in the last bear market we saw small-value do worse than large-growth. The previous bear market it was the other way around. Small-value was so cheap that even though it was exposed to the recession, they still did much better than large-growth. Large-growth got hit in turn because they have gotten priced so high. It's hard to say how it plays out the next time.

Benz: Every market environment is a little bit different. Let's talk about some mutual funds that performed relatively better. You said defensive funds, really across the board, even across asset classes, held their ground better than more aggressively positioned names. Let's start with fixed income. FPA New Income is one that you call out as having held up quite well.

Kinnel: FPA New Income is a fund that's really almost always on the defensive or nearly always in its life, and it's a fund that is particularly interested in protecting against both credit risk and rising interest rates. They've got kind of a quirky portfolio with lots of asset-backed securities but very much focused on protecting against rising rates and sure enough, we had interest rates rise and the fund held up really nicely. It's a fund obviously in good years you are unhappy because other funds have much better returns. But again, it's a very defensive fund and it shows at least that those defenses do work.

Benz: On the domestic equity side, one fund that you note performed quite well relative to its peers, that's Yacktman Fund. It had been through a spate of relatively weak performance but really was able to distinguish itself during this recent period of volatility.

Kinnel: That's right. Kind of like FPA New Income, it's a fund that is defensive enough that it tends to lag in bull markets. It's got kind of a high-quality/value tilt, but also, they tend to build a lot of cash when they don't find enough to invest in. And so, both of those things really worked for them. Obviously, cash is going to have a small positive return in just about any year, but also a lot of their quality names actually made a decent return last year. And so, after a number of years of lagging, the fund did really nicely in 2018.

Benz: Tweedy, Browne Global Value, another fund that we've long talked about as being relatively conservatively positioned foreign stock fund. It too did quite well.

Kinnel: That's right. In this case, they didn't have that much cash, but they did have quality names. And then, on top of that, they hedge their currency. And again, with the rising dollar that makes a really big difference. Again, being defensive in a slightly different way worked nicely for Tweedy.

Benz: Vanguard Global Minimum Volatility also performed quite well, as one would hope, during a period of market volatility.

Kinnel: This is a fund that owns a very wide array of stocks but again positioned toward the lower volatility, and it also hedges again with the idea that currency volatility is something that you can take out of the equation in order to produce a steadier return. And that's what they do and obviously, this was a year where it worked nicely.

Benz: Given all of these forces that are still out there worrying investors right now, I think it might be tempting to look at some of these very defensively positioned names and go fully on board with them. Would you recommend that or what should investors do as 2019 ramps up?

Kinnel: I definitely would not overreact. If you want to tweak your portfolio, maybe you have a really aggressive portfolio, then yes, some of these sorts of conservative funds that we talked about are good. But the rallies can be just as violent as the sell-offs. You don't want to be so positioned that you are not going to really participate in that rally. I think some of these conservative funds are nice. They can help you get through the rough times, but you don't want to completely overhaul your portfolio, because then you are really driving looking in the rear view mirror and that's not a good idea.

Benz: Really thoughtful recap, Russ. Thank you so much for being here.

Kinnel: You're welcome.

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

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Susan Dziubinski: Hi, I'm Susan Dziubinski for Morningstar.com. Mutual funds typically close or otherwise limit new investments when they foresee that ongoing inflows may impact their investing style. In some cases, those funds remain closed. Sometimes, closed funds reopen. Here are three Morningstar Medalist funds that did just that in 2018.

Tony Thomas: Silver-rated Mairs & Power Small Cap reopened to new investors in September, and that's good news for investors looking for a good option in the small-cap space. The fund closed at a fairly conservative $330 million in 2016, but that's typical of this conservative firm that likes to be careful with investors' assets. The managers run this fund well. They execute an excellent process that favors high-quality businesses with defensible competitive positions. Investors that understand its process could have anticipated what's happened with the fund over the last couple of years. In 2017, it really struggled. Its good businesses just weren't as favored in that bull market. But in 2018's more volatile market, the fund has done quite well. So, again, this is a good opportunity for investors to get into this small-cap fund.

Alec Lucas: Silver-rated FMI International reopened to new investors in April of 2018. The fund is managed by Milwaukee-based Fiduciary Management. It takes a team committee-based approach. Key managers on the fund though include Pat English and Jonathan Bloom. They are capacity-conscious and picky about the kind of stocks they put in their portfolio. It tends to be a resilient portfolio. The key thing for investors to understand about this fund is they hedge their currency back to the U.S. dollar and that can sometimes help or hurt returns. It's been a big help in 2018's year-to-date results. Over a full market cycle, we think that this fund should outperform based on the managers' stock-picking skills.

Gregg Wolper: IVA International Fund reopened to new investors recently for the first time since 2011. And while it's not appropriate for everyone, it's definitely worth taking a look. Managers Charles de Vaulx and Chuck de Lardemelle have been running this strategy for many, many years--even before the inception of this fund. It's a cautious strategy and it's unusual. They are looking for stocks that are at deep discount to what they think they are actually worth. If they don't find enough of them, they are willing to hold cash; that level has been over 30% at times. It's down to about 18% at least at the end of October, and could be lower now because they may have taken more advantage of the drops in the market. They will also hold gold. They say that's to protect against unforeseen circumstances. This is not a fund that's going to take full advantage of big rallies in the markets, especially if they are led by growth stocks and investors who want to fund it, will do that, would not be happy here. But over time, it's cautious, careful, low-turnover approach should pay off.

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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Now that we are into the new year, many investors are thinking forward to the next big deadline, April 15. Joining me to discuss some tax reporting issues that have the potential to trip up investors and taxpayers is Tim Steffen. He is director of advanced planning for Baird.

Tim, thank you so much for being here.

Tim Steffen: Good to be back.

Benz: Tim, let's discuss what's changing, some of the highlights in terms of 2018 taxes that will be reflected on people's tax forms in 2019. The 1040 itself is changing?

Steffen: Yeah, 2018 is really the first year of all of these tax reforms that we talked about well over a year ago, are finally taking effect. So, people are going to start seeing it in their returns. Most people should look to see, all things being equal between 2017 and 2018, probably higher levels of taxable income. You've got fewer deductions and changes there, but you've also got new tax rates that apply at everything; you've got changes to things like child credits and AMT and personal exemptions; and all of these other things that have changed. So, the whole tax return process is going to be a lot different this year than what people are may be used to.

Benz: And the form itself is going to look different?

Steffen: Yeah. There's going to be some pretty drastic changes to the form. They talked a lot about the whole postcard thing. They can kind of check the box in the postcard thing. They sort of got there. Basically, what they did is, they took the old 1040 that we're used to, and instead of two full pages they cut it to two half pages. So, you've got a full piece of paper but half of it is empty. To do that they took a bunch of lines off of the return and instead of having it be on the 1040, they are on new schedules.

So, the 1040 says instead of these seven lines of information you used to provide us, put it on schedule 1 or schedule 2 or schedule 3. So, yes, it's a shorter 1040, but it's actually more pieces of paper.

Benz: You brought, though, some tax reporting issues that have the potential to trip up investors or at least be a little bit of a head-scratcher around tax time. Let's start with what's called a qualified charitable distribution. You say sometimes people are confused come tax time if they did that QCD--first, let's talk about what that is--but also how that gets reflected or not reflected on their tax returns.

Steffen: A qualified charitable distribution, that's when somebody takes money directly from the IRA and sends it to the charities. So, it doesn't go through you individually. It goes right from the IRA trustee to the charity.

Benz: And that's only available to RMD-subject investors.

Steffen: You have to be at least 70 1/2 at the time of the gift. So, if you are over 70 1/2, you can make that distribution right to the charity. When you do that, the withdrawal from the IRA is not considered taxable income. You don't get a deduction for the charitable gift either because that would be kind of double-dipping, but you don't have to report the IRA withdrawal as income.

The trick that people run into on that is that your IRA custodian, the brokerage house or wherever you have the IRA held, still has to issue you a 1099 as if it was just a normal distribution out of the IRA that went right to you. In your mind, you made the gift. You are saying, well this is tax-free, I don't have to worry about reporting it. All of a sudden, you get a 1099 in the mail from your broker and you are saying, why did I get this? The issue there is, the IRS tells brokers that's what you have to do. They don't necessarily know if you are going to qualify for all the charitable distribution rules. You might have said, go right to the charity, but the IRA trustee doesn't necessarily know that that's going to qualify. They will issue you a 1099 showing you a distribution that's fully taxable, and then it's up to you to report that on your tax return as actually being a tax-free withdrawal.

The way you do that is, if you can kind of picture the tax form, there's a line for IRA distributions, and on one side, it's total distributions and on another side, it's the taxable. You can put the total amount on the left-hand side, and right next to it just write QCD. Whatever portion is not taxable out of that IRA withdrawal, you just leave that off of the column with all the taxable income. You have to report it correctly in your return, make sure your tax preparer knows you did this, because they may not necessarily know. And then, also, make sure you don't take a separate deduction for the gift as well.

Benz: Got it. Another thing that you said sometimes gets a little bit confusing is, if people have made a nondeductible contribution to an IRA. First, why would someone want to do that? And second, what sort of paperwork needs to accompany that nondeductible IRA contribution?

Steffen: Why would somebody make a nondeductible IRA contribution? There's a couple of scenarios. One is, they are just looking to put up more money into a retirement account and aren't as concerned about the tax benefit of it today. People who are over a certain level of income and are maybe covered by an employer plan, they are not eligible to take a deduction for an IRA contribution. Their income is too high to do a Roth which would be the next thing you would consider. So, then they say I'll put it into the traditional IRA. I don't get a deduction for it, but at least I will get some tax-deferred growth on it until I take it out later in life. They will put their contribution in there.

They may combine then, in some cases, with this whole backdoor Roth thing where you convert the IRA to a Roth. But that's not necessarily always what happens. Sometimes they just leave it in the traditional IRA. Regardless of what ultimately happens once it's in the IRA, it's still important to report that correctly in your tax return.

Benz: OK, and I do that how?

Steffen: The form you are going to use is Form 8606 and that's the form that you use to tell the IRS, I put money into my IRA and I'm not taking a tax deduction for that. The reason you do that is that when you take the money back out of the account later on in retirement, you can take it out tax-free. That form is incredibly useful to document the fact that this money is in there. It's a cumulative form, so, every year you do these contributions, it adds up to the total year-over-year. And then, when it comes to time during retirement to take it out, you take that money out on a pro rata basis. But at least, it tells the IRS you can take that money out tax-free.

Now, if you forgot to do that in the past, and we see that happen sometimes, people think I'm not going to get a deduction for this, I know I'm too high …

Benz: I did that once.

Steffen: There you go. I know my income is too high. I'm not going to even bother telling my tax preparer about it. That's a mistake. Because the preparer needs to know that, so they can fill out that form. If you didn't fill out the form, all is not lost. You can go back and fill out a form for the year that you contributed. Obviously, you got to find the old form which is on the IRS website. You can send that form in. There's a $50 penalty, I think, for each one of those you file late, but at least you get it documented, so that when it comes time to take the money out afterward tax-free, you don't have to worry about the IRS questioning where did this come from.

Benz: Because all the documentation is there.

Steffen: Correct.

Benz: Let's talk about capital gains and losses. I think 2018 may be a year when some investors are able to identify losing securities on their books and maybe did some tax loss selling. You said this is an area that can get a little confusing because you have the opportunity to net the gains and losses. How does all that work, and what kind of reporting do I have to do on that?

Steffen: If I've got a long-term loss or gain and a short-term loss or a gain, can I use those against each or offset each other? And the short answer is, yes. The way the netting works is, if you look at all of your long-term positions, gains and losses, you combine all those long-term ones into one number and you come up with a net long-term position. You do the same thing on the short-term side. All your short-term transactions, gains and losses, combine them all together to come up with the next short-term position. Now, those are both gains, then they are both taxable. If they are both losses, you combine them together and you can use $3,000 of that to offset other income. The rest of that loss carries forward indefinitely, and you can use it every year going forward to offset future gains or the $3,000 per year.

If after you combine them together you have a gain in one category and a loss in the other category, they can offset each other. You can use, for example, a short-term loss to offset a long-term gain--only after they've offset their own kind first. But the short answer is, yeah, you can use losses of one kind to offset gains in the other.

Benz: Last question, it relates to the alternative minimum tax. It sounds like fewer taxpayers will be subject to the AMT than in the past. So, any thoughts on that and what opportunities might be if you've been subject to AMT in the past?

Steffen: The good news is, that with all the changes that ran through the tax reform of 2017 and taking effect in 2018, so many of those changes have combined together to really limit if not almost eliminate the impact of AMT. Some of the studies I've seen have said that we are going to go from 5 million people paying AMT to 200,000. It's really going to have a drastic impact on who pays it.

The good news is, for some people, if you've been an AMT in the past, you may have built up what's called an AMT credit, meaning that extra tax you paid in a prior year, you get to recover that. But you can only recover that in a year when you are not otherwise subject to AMT. So, you may have built up a credit years ago, because of something you did, and you've never been able to use it because you can never get yourself out of AMT. But with these changes this year, so many taxpayers are going to find themselves back out of AMT that those credits, they will be able to start using some of those now.

Benz: Which can further lower their tax bills?

Steffen: Exactly. You can't ever go below the AMT. AMT is a floor. It's the minimum tax. But that floor has fallen quite a bit because of the way the AMT is calculated that that credit you've built up years, you maybe able to use that now. Now, you've got to be careful. That credit is hard to calculate. There's a separate form you use in your tax return, it's form 8801. That's what you use to determine how much of an AMT you paid in a prior is now creditable in a current year. It's a cumulative form; it builds up every year; it keeps your running total of your credit amount. But for a lot of folks those credits have been hanging around for a long time--2018 maybe the year they can finally start to use some of those.

Benz: The good news is, if you use this CPA or if you use good tax-prep software, they are going to flag a lot of these issues for you and kind of walk you through the right forms, correct?

Steffen: Especially, the AMT credit one. The qualified charitable distribution, you'll have to make sure you check the right box in some of those. And again, with the IRA, if you don't tell the person you did the contribution, there's nothing they can do. So, make sure you tell your preparer or your software that you made the contribution.

Benz: Tim, always helpful advice. Thank you so much for taking the time to be here.

Steffen: Good to be here.

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

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Kenneth Oshodi: A well-executed, thorough process and cheap fees make Virtus Seix Floating Rate High Income a solid option among bank-loan funds.

George Goudelias has led the fund since its March 2006 inception and his comanager, Vincent Flanagan, joined him in August 2011. Both maintain sector analyst responsibilities, but they're also supported by seven seasoned high-yield and bank-loan analysts. The team's approach targets securities that it believes are misrated by the ratings agencies and show improvement in their underlying credit metrics. It favors the BB and B tiers of the market, but it also ventures into lower-quality territory. Asset-rich industries like healthcare, energy, and broadcasting are usually among the portfolio's top holdings.

The fund's long-term record is strong, despite some struggles as oil fluctuated in 2014 and 2015. From its March 2006 inception through November 2018, the fund's 4.3% annualized return outpaced two thirds of its distinct bank-loan Morningstar Category peers.

Overall, this fund's experienced and stable team, effective, well-executed process, and affordable expenses support its Morningstar Analyst Rating of Bronze.

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Andrew Lange: We see Blackbaud trading at a healthy discount to our recently revised fair value estimate of $87.

We assign Blackbaud a wide economic moat due to high customer switching costs and intangible assets based on its broad suite of essential relationship-management software and deep knowledge and expertise within the social good community.

The firm's pedigree as a leading on-premises software provider has changed in recent years with management committing to a cloud-based business model transition. Although we expect some near-term lumpiness in Blackbaud's financial performance due to the transition, we think the firm's ability to maintain its industry-leading longevity remains secure, and we see better lifetime value from customers as they move to Blackbaud's cloud platform.

As Blackbaud focuses on selling integrated cloud solutions to its respective markets, we think the firm can reinforce the stickiness of its solutions as it becomes easier for clients to add additional products. While it is early days in the firm's transition to integrated cloud solutions, we think client conversations are now a return on investment discussion rather than a point product sale.

Overall, given Blackbaud's leading products, niche markets, and sticky products, we see the firm as well positioned for the future.

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Eric Compton: 2018 was a great year for the U.S. banking sector operationally, but a terrible year from a stock performance perspective. We started out bearish on banks in 2018, with valuations seemingly pricing in perfection, and bargains were tough to find, however to start out 2019 we feel valuations have become much more reasonable, and we are even beginning to see some bargains.

From a sector perspective, we see one or two more rate hikes likely occurring in 2019, and we are forecasting 2019 to be the last year of material net interest margin expansion. After this, we see rising deposit costs and a slowing rate hike schedule bringing an end to the current NIM expansion cycle. We also still see some excess regulatory capital in the sector, as well as a likely continuation of the strong cost control we saw in 2018.

The remaining NIM expansion, continued cost control, and the release of excess capital should roughly balance out the beginning of a normalization of the credit cycle, and as such, we don't see returns on equity sustainably expanding from here on out. We do expect credit costs to normalize over the medium term, as it appears we are in the later stages of the current cycle, however we don't believe this necessarily means that we are on the verge of another 2008 style downturn for the sector.

From a stock perspective, valuations have become much more attractive, and we view Wells Fargo and KeyCorp as the best risk-adjusted values today. Wells is currently trading at roughly a 30% discount to our fair value estimate of $67. This is well below the bank's historical trading multiples and implies that the Wells franchise is in serious decline. We don't see any reason why the current wave of legal charges and regulatory woes won't eventually be in the rear view mirror, and why Wells won't eventually recover to a high teens return on tangible equity and a more reasonable valuation.

KeyCorp is also nearly 30% undervalued compared to our current fair value estimate of $21. We believe that KeyCorp fundamentally transformed the franchise following the bank's First Niagara acquisition, overall we believe the integration has gone well, and we also believe the bank's credit culture has improved since the crisis. Despite some near-term growth headwinds, we believe the current returns on equity the bank is hitting today are here to stay, and eventually the market will give KeyCorp credit for its much improved operational performance.