Financial advisers should be aware that funds could be doling out large capital gains payouts this year, says Morningstar's Russel Kinnel.
Funds pass through their net gains on stock sales to investors at least once a year, typically at the end of the year. Just how much of a payout investors get depends on the manager's buy-and-sell decisions.
A fund that tends to hold stocks for the long term may have very little in the way of capital-gains payouts. One that trades frequently, or is under heavy redemptions, may have
larger capital-gains distributions.
And many actively managed funds have come under heavy selling pressure this year. Actively managed U.S. diversified stock funds saw a net outflow of $222 billion in the 12 months ended August, Morningstar says, while passive funds saw a net inflow of $175 billion.
Those fund flows may have prompted actively managed funds to sell their holdings to meet redemptions — and that, in turn, could mean higher-than-usual distributions this year, said
Mr. Kinnel, Morningstar's director of manager research.
“We've seen continued stock market appreciation and redemptions for active funds,” he said. “Even if we'd seen a more or less flat year, we might see an uptick because the gains from previous years are still around.” So far this year, the Standard and Poor's 500 stock index has gained 7.39% with dividends reinvested.
Funds typically start to release their estimates for capital gains payouts in October, but a few have already made some distributions.
Fidelity Low-Priced Stock (FLPSX), for example, reported a long-term capital gains distribution of $1.196 per share on Sept. 16. That's about 2% of its previous day's share price.
The American funds have
released estimates of their funds' 2016 distributions. The AMCAP fund (AMCPX), for example, should have a long-term capital gains distribution of 2% to 4% of its share price, the company said. Washington Mutual (AWSHX) should have a distribution of 4% to 6% of its share price.
"Many fund companies are communicating their expectations for gains distributions earlier than they have in the past, which can help clients and their advisers plan for the tax implications," said Maura Griffin, CEO at Blue Spark Advisors in New York. "But it's an inexact science, and it still comes very late in the year, to muddle up the best of strategies."
Distributions from funds held in tax-advantaged retirement accounts don't have to worry about capital gains distributions. And most — but not all — exchange-traded and index funds have very low payouts. Long-term capital gains are taxed at a maximum 20%.
If the market takes a sharp downturn, funds may be able to reduce their payouts by harvesting losses. Funds distribute net capital gains, and can sell their losers to offset gains. If you're an adviser with clients with large actively managed holdings, you can encourage them to use the same technique. If a client has been dollar-cost averaging into a fund over a long period of time, you might be able to identify certain lots that are currently showing a loss and sell them, said Barry Glassman, a financial planner in Tyson's Corner, Va.
Selling the fund before its distribution date probably isn't a good idea, either: You could wind up paying even more taxes on the sale. “There are worse things you can do than buy a successful fund,” Mr. Kinnel said.
Ms. Griffin agreed. "Capital gains distributions have a bad rap, especially after a fund has had a period of lower returns," she said. "I can ease some clients' pain by finding opportunities in their overall portfolios to tax-loss harvest. Often they don't understand the underlying reasons for the cap gain distribution and simply want an explanation."
Weigh the fund's overall prospects and its distributions before considering selling, "The question is, do you want to remain in that fund?", Mr. Glassman said. "If your client bought it six, seven years ago, the chances are you have a significant unrealized gain." And, he said, you could also consider reinvesting the distribution into a more tax-efficient fund.
"In the end, long-term capital gain is a distribution like a
dividend, taxed similarly," Ms. Griffin said. "I am not an advocate of trading in and out of funds before the record date just to avoid capital gains distributions. Would investors sell out of a stock before the ex date to avoid a
dividend distribution? Would someone turn down a raise because he'd pay taxes on it? I wouldn't."
