How Mutual Funds Work - Capital Gains

December 14, 2004

We love mutual funds. Mutual funds provide cheap and easy investment diversification, they're easy to get in and out of, they're highly regulated, and they allow investors access to expert financial guidance at a low price. As investments go, we think that mutual funds are far and away the best option for the vast majority of investors in America.

But there are a couple of things about mutual funds that we don't like. Fund investors never know exactly what they're invested in. Mutual funds sometimes charge fees that are too high. Mutual funds can also hit investors with large and unexpected capital gains distributions.

How big can capital gains distributions get? Just ask shareholders who were invested in the Warburg Pincus Japan Small Company Fund (now called the Credit Suisse Japan Growth Company fund) in 2000.

That fund was down over 60% in 2000, making it one of the worst performing mutual funds in what had been a very bad year for investors. But while lousy performance like that wasn’t going to earn Warburg Pincus any Christmas cards, it was the Godzilla sized 55% (ouch!) capital gains distribution that really hurt shareholders.

An investor who had sunk $10,000 into the Japan Small Company Fund on December 31, 1999 saw the value of her investment drop to $4,000 by year’s end. When the fund issued the 55% distribution near the end of 2000, her shares dropped a further 55% in value (when a fund issues a distribution to its shareholders, the value of the fund drops by the exact amount of the distribution), and she received a taxable dividend distribution of $2,200. If she was in the 31% income tax bracket and she owned the fund in a taxable account, she would have owed the IRS $682 in tax on an investment that had already cost her $6,000. Not a good year.

To understand how you can get hit with a big capital gains tax bill from your mutual fund, you’ll need to know a little about the complex world of fund distributions.

By law, funds have to distribute any taxable gains from investing to shareholders each year.

Your fund has profits and losses much like your own portfolio does. Funds can have losses from bad investments, gains in the form of short term or long term capital gains, ordinary income, and now, low tax dividend income.

Each year the fund accountants figure out how much income there is of each type. The tax liability is then passed on to the shareholders in the form of a dividend (the tax rate for each depends on the shareholder), which is why none of this matters in a tax deferred account like an IRA or 401(k).. .

Most investors choose to reinvest these dividends automatically, which means that the fund company converts shareholder’s capital gains and dividend money into more fund shares with the cash. The total account value doesn’t change, but shareholders wind up with more shares at a lower NAV.

To really understand what is going on behind the scenes, we’ve launched the hypothetical SuperMAX Growth and Income fund (SMGIX), and all stock offering.

Unlike real stock funds, SuperMAX Growth does not have to be diversified. In fact, the fund manager owns just two stocks: Apple Computer (AAPL) and Exxon Mobil (XOM). The fund had $1 million in assets a year ago and put half the portfolio in Apple and the other half in Exxon Mobil. Apple is a growth stock, while Exxon is a more income-oriented stock that pays a decent dividend – so the fund is keeping with its name.

About a year ago Apple stock was at $20 and Exxon around $36. Today Apple is at $68 and Exxon at $51, or up about 240% and 44% respectively. Because of these big gains, this fund has returned 142% for the year, which turned out to be a very good twelve months for iPods and Big Oil.

Figuring the capital gains on that 142% can get awfully tricky. Different potential tax distributions can occur depending on how the fund manager trades and how the fund has done in the past, as well as how popular the fund is with investors.

Scenario 1 – Buy and hold

If the fund manager of the SuperMAX fund never sold any stock, there would be little in the way of taxable distributions because the fund would never have realized any of these profits. A stock can go up forever—if the fund manger doesn’t sell any stocks at prices higher than he bought them, no gain is realized and no tax is due. (Do you think that doesn’t happen? It does. The Vanguard 500 Index fund is sitting on over twenty billion in unrealized gains.)

In fact, the only income to the SuperMAX fund is the dividend generated by the Exxon holding. Exxon paid a 3% stock dividend last year, so a fund shareholder could expect to receive a small dividend of about 1.5% of the fund’s NAV. This is because half the fund was in Exxon (at least before Apple stock took off).

BUT WAIT! Since most funds take management fees out of dividend and bond income first, it is very rare for a fund investor to get any dividend income. The simple reason is that most stocks barely pay a dividend higher than the fund management fee. Only those in high dividend funds or in funds with very low fees even see stock dividend distributions.

Scenario 2 – Buy and sell in less than a year

If the fund manger sells the Apple stock before the end of the year, shareholders could get hit with a big, taxable capital gain. Even worse, the gain will be passed on as a short term gain, which is taxable at shareholder’s ordinary income rate. Ouch!

Why would fund managers sell before the year is out when it could mean pain for the shareholders? Because they couldn’t care less about your problems, and because funds are ranked by their before-tax returns. Most fund managers are interested only in generating as large a total return as they can, because the bigger the number they can print in their magazine ad, the more performance-chasing investors they’ll attract.

Scenario 3 – Buy and sell in more than a year

If the fund manger sells the Apple stock after they have owned it for a year, but before the end of the fund fiscal year, shareholders will get a capital gains distribution. But it will be a low tax rate, long term gain.

Scenario 4 – Big losses on the books wipe out gains

If the fund manger sells the Apple stock and realizes the big gain, but has even bigger losses on the books from previous trades, the gain could very easily be wiped out – leaving shareholders without a big tax bill. Imagine that the SuperMAX fund bought Cisco near $100 a share in 2000 and sold at a loss in 2002 to raise cash to meet shareholder withdrawals. This scenario applies to many formerly hot funds that have rebounded recently. Few emerging market or precious metals funds ever pay big taxable gains because investors keep buying them high and selling them low, creating taxable losses on the fund books as the manager matches the flows.

Scenario 5 – Inflows of new money water down gains

If the fund manager sells the Apple stock and realizes the big gain, but gobs of new shareholders buy the fund in November because they see how well the fund has done, few investors in the fund from a year ago will be hit with much of a distribution. Funds figure out how much they have made in taxable distributions, and they will make that distribution to all the shareholders on the record date near the end of the year - even to shareholders who just bought the fund. This means if the fund brings in $100 million in new cash, the million or so in Apple stock gains and Exxon dividends will get passed on to all – maybe just $.02 cents per share in distributions. In this case, investor’s performance-chasing ways benefit those who got in when nobody wanted the fund. Late investors literally bought early investor’s tax liabilities.

Scenario 6 – Outflows of Money increase gains

This is a very rare scenario as fund investors are not very timely with their investments. Let’s say nobody new buys the hot, hypothetical fund after the big 142% run-up because they have listened to MAXfunds about watching out for the hottest funds of the past year.

Even worse, imagine if half of the shareholders in the fund cash out in November – partially because they don’t want to get hit with a dividend, and partially because they don’t think Apple and Exxon will be very good bets in 2005. If half the shareholders depart, the fund still has to distribute all the realized gains from the Apple sale, but now to only half the shareholders. This could lead to a traumatic event because current shareholders are getting the taxable gains of others shareholders who left before the distribution. Sad but true – although very, very rare, this once happened with a certain Japan fund in 2000.