It’s hard to imagine mutual fund managers nostalgic for the big losses many booked in the financial crisis. But for actively managed funds, those realized losses did come to serve one useful purpose — as the bull market stretched on and managers took profits, they offset capital gains.
Six years into a bull market, those losses are largely used up. That means more investors who own actively managed funds in taxable accounts will confront the biggest taxable distributions seen since before the crisis.
Funds run by the Morgan Stanley Growth team, which Morningstar crowned 2013′s stock fund managers of the year, give a glimpse of tax pain to come. The group estimates it will distribute taxable gains equal to 12 percent of the Morgan Stanley Midcap Growth fund’s net asset value (NAV). At T. Rowe Price, shareholders in the Global Technology fund will get a distribution equal to more than 20 percent of the fund’s NAV. Vanguard MidCap Growth is on pace to distribute nearly 12 percent of its NAV, as is Oakmark Select.
Any time a fund books a gain it is required to pass it along to shareholders. The gains can be short-term, which are taxed as ordinary income, or long-term and taxed at rates typically well below the ordinary income tax rate.
So far, more than 500 funds have said they’re likely to make taxable distributions that top 10 percent of their NAV, according to capgainsvalet.com, a website that tracks mutual fund gains distributions. That’s more than a 70 percent increase from the 291 funds Morningstar found making distributions of at least 10 percent in 2013, and higher than the 496 funds that did so in 2007, the last year before big stock market losses came into play.
More than 60 of those 500 funds are on pace to dole out distributions of more than 20 percent, says Mark Wilson, chief investment officer at the Tarbox Group, a wealth management firm. In all of his years of gains-spotting, he says, distributions of more than 10 percent of NAV have been atypical. Wilson launched capgainsvalet.com in November and has collected distribution information from more than 200 of the largest investment firms.
Big capital gains distributions may not bother investors if they’re paired with big returns. That’s the situation at Oakmark Select, which took profits this year after big gains. Three of the holdings in the highly concentrated fund — Forest Laboratories, DirecTV and TRW Automotive — were all bought out in 2014 deals, adding to fat profits they’d already made for fund shareholders.
For the three years through November, Oakmark Select’s annualized return was 24 percent. Morningstar calculates that after factoring in the bite of taxable distributions that return drops to 23 percent. Over 15 years the fund’s 10.6 percent annualized gain is reduced to an after-tax 9.9 percent.
By comparison, the uber-tax efficient Vanguard 500 Index fund has a 3-year annualized return of 20.7 percent and a 15-year average gain of 4.6 percent.
Tax Planning for 2015
Investors trying to be more tax-efficient in 2015 should remember to keep actively managed funds in tax-deferred accounts. Taxable distributions are a non-event if the fund is owned in a 401(k) or IRA. For active funds held in taxable accounts, focus on the fund’s after-tax payoff to make sure it delivers some value-add beyond what an index fund or ETF provides.
To find out a fund’s after-tax payoff, enter a fund’s ticker at Morningstar.com and click the Tax tab on the quote page. That page has historic after-tax gains, as well as the fund’s tax cost ratio, which is the percent of the fund’s return that was lost to taxable investors. Funds with low turnover — meaning the manager doesn’t constantly make trades that can generate taxable gains — typically have lower tax cost ratios.