Some funds doling out capital gain pain

Small-cap funds dishing out big gains in a hot year

Nov 23, 2016 @ 7:00 am

By John Waggoner

If your clients don't believe taxes are important, here's a nugget for them: Out of 367 large-company blend funds with five-year records, just 30 have beaten the Vanguard 500 Index fund after taxes.

On average, those 367 funds lost 1.75% in return to taxes, according to Morningstar (MORN). While the Vanguard 500 Index fund isn't immune to taxes — it shed 0.61 percentage points of return a year to taxes, thanks to dividends — it's as close as many investors get to investing in the Standard & Poor's 500 stock index itself.

Don't expect any relief this year. Funds are putting out their estimates for capital gains distributions, and after a seven-year bull market, few funds have offsetting losses to reduce those gains.

Fidelity Contrafund (FCNTX), for example, is handing out an estimated $2.527 per share in capital gains and another 17.3 cents per share in income this year. Against a $102.10 share price on Sept. 30, that's a relatively modest 2.6% distribution.

Fidelity's Extended Market Index fund (FSEMX), however, is doling out 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. Total: $2.025 per share. The fund's share price was $54.66 on September 30, meaning an unusually large payout of 3.7%.

But many fund companies are preparing to dish out much worse capital gain pain.

A handful of funds will stick investors with payouts equal to 20% of their share price or more. Columbia Disciplined Small Core Fund (LSMAX), for example, is estimated to have a distribution of 37.28% to 39.93% of its net asset value. Three other funds — Delaware Smid Cap Growth (DFCIX), Transamerica Small Cap Growth (ASGTX) and Victory NewBridge Large Cap Growth (VFGAX) — will all have distributions of more than 30% of their net asset value, according to CapGains Valet, a website.

Many of the funds paying outsized distributions are small-company funds, which have been on a tear this year. Small-value funds, for example, are up an average 20.27% this year, and small-blend funds are up 16.48%. Small-growth funds are the laggards, and they're up an average 10.78%.

According to tax law, funds don't pay taxes on the gains they make when they sell securities, or on the income they get from dividends. They pass those liabilities on to the shareholder. The funds pay out their income and capital gains each year, typically in December, or November.

Investors in retirement accounts don't have to worry about capital gains payouts, but those in taxable accounts do. And over time, those distributions can be a considerable drag on returns. Consider Henssler Equity Investor (HEQFX), which earned an average 9.86% a year before taxes the five years ended Oct. 31. An investor who held the fund for five years, however, got an after-tax return of 3.71%, according to Morningstar. And that's assuming the investor didn't sell at the end of the five years and pay taxes on those gains.

You can, of course, have above-average after-tax returns if you have great pre-tax returns. Lazard U.S. Equity Concentrated Institutional fund (LEVIX), for example, gained an average 15.39% before taxes and beat the Vanguard 500 Index fund after taxes by about half a percentage point. But most of the funds that beat the Vanguard 500 Index fund did so by turning in good returns — and keeping an eye on the tax bill.


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