Some investors in actively managed mutual funds can expect to incur big
capital-gains tax bills this year, as continued outflows and lofty returns combine to stymie those holding funds in taxable accounts.
Assets have continued to bleed out of many active funds as investors seek out their lower-cost index counterparts.
The tax hit for owning an active fund may appear counterintuitive: Why would investors owe tax on a fund that has seen an overall decrease in its net asset value?
It's because asset managers are forced to sell out of fund positions to meet investors' redemption requests. Since those positions are likely up big in 2019 as a result of the stock market's strong performance, many investors will likely incur hefty capital-gains taxes due to the fund turnover. The fund redemptions also mean there would be fewer shareholders to share those distributions.
"A lot of the factors that over the past couple of years have conspired to lead to big payouts are in place for 2019," said Christine Benz, director of personal finance at Morningstar Inc.
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Investors would incur these taxes by way of a capital gains distribution. These payments represent the investor's share of proceeds from the fund's sale of stocks and other assets.
Mutual funds typically pay these distributions at the end of the year. While investors may choose to reinvest the distributions, they are still liable for taxes on the payouts at short- or long-term capital-gains tax rates.
These taxes don't apply to investors holding mutual funds in nontaxable accounts like 401(k)s and IRAs.
Financial advisers and their clients usually can get an idea of what the distributions will be starting in late October or early November, when fund companies typically provide estimates, Ms. Benz said.
Here's an example posed by Russel Kinnel, director of manager research at Morningstar, in a recent blog
post.
In 2017, the Hennessy Focus fund (HFCSX) paid out a half-penny of capital gains per share on a net asset value of $87.76, after returning 19.27%. In 2018, the Hennessy fund paid out a much larger $14.47 per share on a lower net asset value of $67.71, despite a negative 10.47% return.
The dynamic is the result of fund flows. The Hennessy fund saw a modest $148 million flow out of the fund in 2017, but a more substantial $792 million outflow in 2018 from an asset base that started the year at $2.8 billion.
Experts expect to see the lion's share of distributions this year among actively managed domestic equity funds, which have had high returns and substantial outflows.
Active U.S. large-cap growth funds, for example, have returned 22.3% and seen $27.7 billion of outflows this year through Aug. 31, according to data from Lipper.
A large drop in interest rates on 10-year Treasury bonds in August may also lead to a tax hit for bond-fund investors if those moves led to a flurry of trading by fund managers, experts said.
The problem isn't necessarily a new one for shareholders in active funds. The past 10 years have seen $1.3 trillion in outflows from active U.S. equity funds, while passive funds have gained nearly $1.4 trillion at the same time that there's been a decade-long bull market in stocks.
Fund managers were able to tamp down on capital gains distributions in the years following the 2008 financial crisis by
offsetting their gains with realized capital losses. However, those realized losses have long been extinguished at this point, said Leon LaBrecque, an adviser at Sequoia Financial Group.
"This will be a year in which we'll be very vigilant," Mr. LaBrecque said about paying attention to capital gains distributions.
He may recommend that clients sell a mutual fund before the end of the year if it's expected to have a large distribution and a loss in net asset value, and then swap into a similar mutual fund or exchange-traded fund.
It doesn't always make sense to sell preemptively, Ms. Benz said. If a fund shareholder reinvests a capital gains distribution, it adjusts the fund's cost basis upward, which means an investor would have a lesser capital gain (and a lesser resulting tax on that gain) when the position is ultimately sold. So advisers should check clients' cost basis before having them sell a holding.
