“I’m avoiding a fund because it made a big distribution of capital gains last year,” an investor told us.
He owns funds in a taxable account, which means he’ll pay taxes on any distributions he receives, so he understandably wants to avoid investing in a fund now that could be a tax liability at year end.
However, a fund’s distribution history isn’t necessarily a good indication of future distributions.
Mutual fund distribution season is right around the corner (most funds distribute in December, while some do so in November), so this is a good time to review some of the factors that can affect a fund’s distribution amount and what investors who own funds in taxable accounts can do to manage the tax implications of distributions.
5 factors that affect fund distributions
Mutual funds are required to distribute the income they receive and capital gains they realize during the year to their shareholders. Fund distributions tend to change from year to year depending on the securities they own, the trades they make, and the number of shares outstanding. Here are five factors that can affect fund distributions:
1. Market action
When stocks are up strongly, a value fund manager may sell securities that have appreciated to a point that management no longer believes them to be attractively valued. This can result in higher distributions to shareholders at year end.
2. Investor behavior
Alternatively, when stocks in a growth fund are plummeting and investors are selling out in droves, management may be forced to sell long-held positions to meet an onslaught of redemptions. At the end of the year, the fund may end up distributing more gains to a smaller number of remaining shareholders.
3. Management changes
If a fund’s manager or subadvisor changes, new management may decide to reshuffle a fund’s portfolio, realizing gains and potentially driving up the fund’s distributions. In 2018, Class 3 Harbor International (HIINX) distributed nearly 40% of its net asset value after a new subadvisor came on board. (HIINX has not made a capital gain distribution since.)
4. Fund closures
When funds close to new investors, they limit inflows, and if outflows increase, funds can end up paying larger distributions to a smaller pool of shareholders.
5. Embedded gains
A fund that hasn't made large distributions in recent years may simply have large “embedded” capital gains—meaning gains that haven’t been realized yet—or it may have offset its gains with losses.
Like individual investors, funds can use realized losses to offset gains, and losses can be carried over into future years. After the 2008 bear market, some funds had so many losses on the books that they didn’t make capital gains distributions for years. At the time, these funds may have looked extremely tax efficient, but once they’d used up their losses, the funds started distributing capital gains again.
How advisors handle year-end distributions
Given that distributions are so unpredictable, what can investors do now if they own funds in a taxable account? First, pay close attention to distribution estimates. This is what we do in the accounts we manage for our wealth management clients. Most funds will post estimates on their websites in the next month or two, and this is the most reliable way to determine which funds are planning to make distributions this year and how large these distributions might be.
We can use these estimates to avoid buying into funds that are about to make big payouts in the taxable accounts we manage, and, at times, we may favor ETFs, which typically don’t make capital gains distributions. If a fund we already own expects a distribution, we carefully analyze each fund and trade lot in an effort to make tax-smart decisions for clients.
The takeaway here is that there are no shortcuts to help you determine which funds will make year-end distributions. Every year is different. So, if you own funds in a taxable account, make sure you’re trading carefully at year end and setting aside extra time to keep up with distribution estimates and decide what action to take if a fund you own expects to make a big payout.
If you need help managing the tax consequences of your investments, click here to set up a time to talk with a FundX advisor. There are often many opportunities to make tax-efficient moves in the last months of the year.