Mutual fund outflows add to the pain of capital gains distributions

Mutual fund outflows can spell capital gains disaster and this year, some funds with low turnover are reporting sizable capital gains distributions as managers sell securities to meet investor withdrawals.

It’s that time of year again, when turkeys get stuffed, halls get decked and mutual fund investors get hit with year-end capital gains distributions.
For investors and financial advisers, it is a frustration as old as the actively managed mutual fund, and every year it seems to hammer another nail in the coffin of active funds.
Even without selling shares of a mutual fund, investors can incur capital gains taxes triggered by security sales within the fund. And those security sales are often driven by net outflows from the fund, which leaves fewer investors to absorb the capital gains distributions.
Add to that the reality that net outflows often are sparked by poor performance, and the double whammy of capital gains distributions can become a triple whammy, or worse.
By way of a positive spin, Morningstar Inc.’s director of personal finance, Christine Benz, said it can be viewed as “prepaying your tax bill,” which isn’t a great tax-management strategy, but at least it’s better than feeling like you’re just setting fire to your money.
The prepayment mentality might be vexing, but it does effectively reset an investor’s cost basis to reflect the capital gains distribution.
For example, if you purchased a fund at $10 a share and get a 10% capital gains distribution from the fund, your cost basis will adjust upward by 10% to $11. Thus, if you sell the fund in the future for $15, you will pay the taxes on the difference between $11 and $15, instead of between $10 and $15. And those calculations are now being done by the fund companies.
That is likely the only real upside of those pesky capital gains distributions.
ETFs IN TAXABLE ACCOUNTS
Ms. Benz, who admits she personally owns actively managed mutual funds in taxable accounts, believes annual capital gains distributions will continue to drive investors toward index-based strategies, including exchange-traded funds, in taxable accounts.
“The capital gains from active funds certainly makes the case for passive funds,” she said. “I’ve become convinced that investors really ought to think twice about investing in active funds in a taxable account.”
Among the biggest challenges with regard to capital gains distributions is that they can crop up despite the best intentions of portfolio management teams, and they are becoming increasingly difficult to predict.
Todd Rosenbluth, director of mutual fund and ETF research at S&P Capital IQ, is lightly chastising himself for previously placing extra emphasis on portfolio turnover rates as an indicator of tax efficiency.
The trouble with relying on average annual turnover rates is that it becomes a lagging indicator because it doesn’t take into account the effects of recent net outflows on the portfolio.
“Outflows mean the portfolio manager has to use cash on hand or sell existing positions to meet those redemptions,” Mr. Rosenbluth said. “Even if a fund has a long-term investing strategy, when they need money, they will need to sell winners and there can be a sizable capital gains.”
Take, for example, the $8.8 billion Columbia Acorn Fund (ACRNX). The fund’s latest prospectus lists a turnover rate of 17%, but through October of this year it has had more than $7 billion worth of net outflows, and is expected to pay a capital gains distribution of more than 30% this year.
The fund is up 2.4% this year through Monday, compared with a 3.3% gain in the S&P 500 Index over the same period.
MANAGER CHANGE
Sometimes a sudden capital gains hit can be attributed at least partially to a manager change, which occurred at the Columbia Acorn Fund in early 2014.
But that is not the case with the $1 billion RidgeWorth Small Cap Value Equity Fund (SASVX), which has had the same portfolio manager since 1997. It has a prospectus-listed turnover rate of 10%, yet the fund had nearly $840 million in redemptions this year through October, and is expected to pay a 2015 capital gain of more than 20%.
The fund is down 2.4% from the start of the year.
Of course, the flip side of that net outflow impact can be seen. The $30.6 billion T. Rowe Price Blue Chip Growth Fund (TRBCX) reports a 32% annual turnover rate, but has experienced $1.3 billion in net inflows this year and is expected to pay a capital gain of just 3.3%. The fund is up 11.2% this year.
“We still think low turnover can be a useful guide to potential capital gains, but this is a year where the metric doesn’t tell the whole story,” Mr. Rosenbluth said. “We’ve seen funds that invest with a long-term horizon that typically have held stocks for two or three years consistently, and they are facing redemptions, so they’ve had to tap some of their winning positions to meet redemptions.”
For portfolio managers — and, ultimately, investors in actively managed funds — the battle for tax efficiency becomes that much more difficult when active management starts falling out of favor.
It would be a stretch to suggest active management is going the way of the buggy whip, but over the 12-month period through Oct. 31, actively managed U.S. equity funds suffered nearly $153 billion in net outflows. Over the same period, passively managed U.S. equity funds, including ETFs, enjoyed more than $120 billion in net inflows.
The message seems pretty clear: For the time being, actively managed funds are best suited for qualified accounts.