The global financial crisis that began in late 2008 took a heavy toll on equity investments. Portfolio values dropped and some investors thought the end of the world was coming. Recent years have been much kinder to investors: since the bottom of the market in 1Q 2009 through the end of October, the S&P 500 is up more than 150%.
Despite the recent strong returns, capital gain distributions from funds have been relatively low, helping keep taxes low for fund investors. The light capital gain distributions from funds resulted from large loss carry-forwards. Those loss carry-forwards are one of the few positives resulting from the crisis, essentially providing a brief vacation from capital gains taxes. By now, many managers have used up all of their loss carry-forwards, and for investors the vacation from capital gains may be over. This comes at a time of much higher tax rates. But it is not all bad news, as there are ways for investors to extend this vacation.
When a mutual fund manager sells a stock and realizes a gain, that gain is distributed to fund investors (and reported on their individual IRS 1099 forms). If the mutual fund manager realizes a loss, the loss can be used to offset the fund's realized gains in a given tax year. If the fund has more losses than gains in a given tax year, those losses can be carried forward to offset future gains for the fund. The losses are not passed through to the investor. During the financial crisis, mutual funds realized lots of losses but had few gains to offset those losses. This resulted in large loss carry-forwards.
At the bottom of the market in 2009, many mutual funds had large loss carry-forwards on the books. One way to examine funds is to use Morningstar's Potential Capital Gains Exposure. Measured for each fund, the larger this ratio, the larger the potential capital gain distribution. If this value is negative, it means that the fund has a net loss position and potentially a large loss carry-forward. Our examination of Morningstar data shows that at the end of 2008, nearly all equity funds (97%) had a negative PCGE. From 2009 to 2013, funds distributed relatively little in capital gains. In fact, all the capital gain distributions made between 2009 and 2012 total only $230 billion, less than each of the single year's distributions in 2006 and 2007.
THE BUCKET IS DRAINED
However, those carried-over losses have already been used to offset recent gains, and the loss carry-forward bucket is drained. Morningstar's current data shows that less than 13% of funds have a negative PCGE. We now expect a return to periods of larger capital gain distributions and taxes for investors. And for some investors, the tax bill will be higher.
For top-bracket earners, the impact of capital gains tax and the new 3.8% Medicare tax on unearned net investment income, combined, results in tax rates of 23.8% on long-term gains and 43.4% on short-term gains — a large jump from 2012 tax rates of 15% and 35%, respectively. Extending the capital gains shelter is still possible through tax management techniques such as loss harvesting. Securities held below their cost basis can be sold to realize a capital loss, which then can be used to offset current gains. However, to prevent purely tax-motivated sales of securities, the Internal Revenue Service restricts buying back “substantially identical” securities within 30 days of the sale. This is known as the wash sale rule. While many investors wait until year end to harvest losses, we find that it is more effective to monitor the portfolio actively throughout the year and harvest losses in the portfolio systematically as they become available. Active tax management works with both passive and active investing styles, but in all cases requires skill and experience to simultaneously preserve pre-tax performance and manage taxes.
While the global financial crisis seems far behind us now, we can be thankful for the vacation from fund capital gain distributions it provided. As funds use up their loss carry-forwards and markets continue to produce strong results, this “tax vacation” will be coming to an end soon. When this happens, tax management techniques such as loss harvesting and tax-managed indexing become even more valuable.
Rey Santodomingo is director of investment strategy for tax managed equities at Parametric Portfolio Associates.