Mutual fund investors that got hit by the market pullback in 2018 will likely take another blow as many funds distribute capital gains. On the other hand, exchange traded funds will be able to highlight their tax efficient nature.
Mutual funds must distribute all their realized capital gains or profits on securities sold during the year. Mark Wilson of Mile Wealth Management and proprietor of CapGainsValet.com pointed out that as of the end of November, 517 funds announced they will pay at least 10% of net assets as taxable gains, and he projected that 531 funds will pay such large taxable distributions by year end, writes Jason Zweig for the Wall Street Journal.
Among the most widely held or largest active mutual funds on the market, the Fidelity ContraFund (FCNTX) showed a 7.2% capital gains distributions based off its most recent December long-term capital gain per share distribution and reinvestment price. Additionally, the Vanguard Wellington Fund Admiral Shares (VWENX) had a 6.4% distribution, The Growth Fund of America (AGTHX) had a 11.8% distribution, The Income Fund of America (AMECX) had a 7.5% distribution and Dodge & Cox Stock Fund (DODGX) had a 6.8% distribution.
In a year marked by volatility, investors have dumped active funds and turned to index-based funds. Active fund managers needed to sell off much of their portfolios to pay out the departing clients, and they are running out of holdings to sell at a loss to offset gains for tax purposes. Consequently, the liquidated positions can create a taxable gain, which is then dividend among the mutual fund investors whom are still sticking around.
On the other hand, ETFs are expected to distribute fewer meaningful capital gains this year, with only two ETFs from the largest fund sponsors expected to dish out cap-gains distributions of greater than 10% and most ETFs not expected to distribute any capital gains at all, writes Adam McCullough for Morningstar.
ETFs are typically viewed as a more tax efficient investment vehicle when compared to mutual funds because ETFs usually enact lower turnover strategies than actively managed funds, which diminishes realized capital gains and makes capital gains distributions less likely, and the ETF investment vehicle enjoys the structural benefits of so-called in-kind transactions where redemptions are conducted through tax-free transactions of ETF shares for a basket of underlying securities.
As of early December, 15 ETF providers published capital gains estimates for the year, including BlackRock’s iShares, Vanguard, State Street Global Advisors, Invesco or formerly PowerShares, Charles Schwab, First Trust, WisdomTree, VanEck, PIMCO, DWS or formerly Deutsche Asset Management, Fidelity, Goldman Sachs, Global X and OppenheimerFunds.
These 15 fund sponsors represented 1,290 ETFs and $3.4 trillion in assets under management. Of the ETFs in question, 74 or only 5.7% of the total are expected to distribute capital gains for 2018. Furthermore, the percentage of ETFs distributing capital gains is lower than the estimated distribution in both 2017 of 7.7% and 2016 of 7.0%. Only 14 of the 1,290 ETFs this year is expected to show capital gains distributions of over 2% of the fund’s NAV as of the end of November.
ETFs are not immune to capital gains distributions. Some fund strategies typically exhibit a greater likelihood of capital gains distributions. For example, currency-hedged strategies have a higher proportion of funds that distribute capital gains due to the underlying currency swaps. There are several defining characteristics that make some ETFs more prone to issue capital gains. Specifically, ETFs that use derivatives that periodically reset are susceptible to capital gains distributions, which usually includes currency-hedged strategies. Additionally, bond funds can also be more susceptible as funds must sell bonds upon maturity, which can result in a gain.
“Most ETFs, especially those that track broadly diversified, market-cap-weighted indexes, are very tax-efficient. Exchange-traded funds that move beyond the area of plain-vanilla may be more susceptible to capital gains distributions. Tax-conscious investors would do well to understand the tax implications of more complex ETF strategies, and scrutinize the tax record of these strategies before investing,” McCullough said.
For more information on ETFs, visit our ETF 101 category.