One of the disadvantages that comes from having a seven-year bull market for actively-managed mutual fund investors is the distribution of capital gains. The markets have risen steadily since 2008, and many funds no longer have much in the way of losing positions that they can use to offset their gains. Taxes can be a big drag on the performance of actively-managed funds, and investors should be prepared to see some potentially big numbers on their capital gains tax forms this year.
Investors who don’t think that taxes matter should take note that only 30 out of 367 large-cap blend funds have outperformed the Vanguard 500 Index fund (VFINX) after taxes over the past five years, InvestmentNews reports. (For more, see: The Basics of Income Tax on Mutual Funds.)
Big Capital Gains
Mutual funds are required to pass through their accumulated gains and losses to shareholders of record near the end of each year, in November or December. Shareholders will receive a commensurate amount of taxable gains and losses based upon the purchase and sale of the securities held by the fund during the year. These capital gains (or losses) are in addition to any capital gain that the shareholders will receive when they sell shares of the fund at a gain or loss. Of course, these gains and losses are only reportable in taxable retail accounts. The distributions have no effect on fund shares that are held inside an IRA or qualified plan.
Morningstar Inc. has reported that the average fund from the aforementioned group lost 1.75% of its return to taxes. The Vanguard 500 Fund has lost an average of 0.61% to taxes each year that are generated from the payment of dividends. But the taxable capital gains that are passed through to investors this year may be much worse in some cases than in past years.
How Are Capital Gains And Dividends Taxed Differently?
Fidelity Contrafund (FCNTX) is passing through an estimated $2.527 per share in capital gains and another 17.3 cents per share in income this year, which comes to a total distribution of around 2.6%. The Fidelity Extended Market Index fund (FSEMX) is passing through a larger amount of its gains, with 14.8 cents in non-qualified dividends, 30.4 cents in qualified dividends, 1.6 cents in short-term capital gains and $1.557 in long-term capital gains, coming to a total of $2.025 per share, or about 3.7% of the fund’s share price as of September 30. (For more, see: How Tax-Efficient Is Your Mutual Fund?)
But these are paltry gains compared to what some funds are going to dish out. There is a small group of funds that are going to stick investors with gains in the 20% to 40% range. The Columbia Disciplined Small Core Fund (LSMAX) is projected to post gains of 37.28% to 39.93% of its net asset value (NAV). CapGains Valet, a website that monitors mutual fund capital gain distributions, has also estimated that three other funds - Delaware Smid Cap Growth (DFCIX), Transamerica Small Cap Growth (ASGTX) and Victory NewBridge Large Cap Growth (VFGAX) - are all going to post capital gains distributions in excess of 30% of their net asset values. Many other small-cap funds also have large distributions to pass through, because this collective group of funds posted returns in the 10%-20% range this year and have accumulated substantial short-term gains.
The Bottom Line
Investors who hold shares of actively-managed mutual funds in their taxable retail accounts may be getting a rude surprise when they receive their 1099-Bs next year. Many mutual funds have posted substantial gains that they will have to pass on to their shareholders without any losses to offset them. Consult your tax advisor to see what you can do to reduce your capital gains bill. (For more, see: Understanding Taxes on Mutual Funds Dividends.)