Image Credit: Christophe Vorlet
By Jason Zweig | Nov. 10, 2017 11:27 am ET
Index funds are supposed to meet expectations almost exactly — but once in awhile they can hand investors an unpleasant surprise.
These mutual funds and exchange-traded funds passively track the performance of a basket of stocks, bonds or other assets. They seek to match the market, not to beat it. After costs and taxes, they should provide returns almost identical to those of the underlying investments they hold.
Then there is PNC S&P 500 Index Fund.
Next month, PNC has announced, the fund will pay out $4.19 in capital gains per share. This week, the fund’s per-share value was around $19. So, even if you never sold a share, the fund will pay out nearly 22% of your total investment as a taxable gain.
Unless you own it in a retirement account, you’d owe approximately $325 to $515 in federal tax on a $10,000 holding, depending on your tax bracket. That would put something between 3% and 5% of your investment straight into Uncle Sam’s pocket. (To be fair, you would owe proportionately less in future taxes if you sell down the road.)
So, even though the PNC index fund has come within a third of a percentage point of matching the S&P 500’s 17.4% return so far this year, its investors will fall badly behind the market after they pay their taxes.
How can that happen?
In general, when investors exit a fund, it may cash out of some of its holdings, potentially generating a taxable gain that must be paid out to the remaining shareholders.
In recent years, at least, more investors have wanted to buy index funds than sell, tending to make such portfolios unusually tax-efficient. Vanguard 500 Index Fund hasn’t paid out a capital gain since December, 1999, according to Morningstar; State Street Institutional S&P 500 Index Fund hasn’t paid one since December, 2000.
A spokesman for PNC Funds declined to comment.
However, investors withdrew $63 million from the fund, or 38% of its assets, over the 12 months through Sept. 30, Morningstar estimates.
The manager of an index fund doesn’t have much flexibility on which shares to sell when investors want their money back, says Mark Wilson, president of Mile Wealth Management in Irvine, Calif., whose website CapGainsValet.com warns about taxable payouts.
That’s because such a portfolio needs to hold stocks in similar proportions to the index it’s seeking to match. So the manager can’t always sell selected holdings at a loss that would offset gains elsewhere. Instead, he or she has to sell pretty much across the board, which can generate unwanted capital gains.
Launched in early 2000, the $125 million PNC fund tries to match the market, before expenses.
Its prospectus explains that the fund manager may use futures contracts on the index, or various exchange-traded vehicles, “in addition to, or in place of,” the stocks in the S&P 500.
Over the past 10 years, the fund has trailed the S&P 500 by 0.29 percentage points, or a bit less than its average expenses over the period. So it has come close — but only before tax. PNC S&P 500 Index Fund’s 7.2% average annual return over the past decade shrivels to 6.2% after tax, estimates Morningstar.
PNC isn’t the only index fund that doesn’t always behave like its underlying investments. Rydex S&P 500 Fund is a $256 million portfolio that seeks to match the market with swaps, options, futures contracts and other indirect techniques, in addition to the stocks themselves.
So Rydex S&P 500 turns its portfolio over at an annualized rate of 133%, implying that it holds its average investment for, at most, nine months at a time. Most S&P 500 index funds have turnover rates of 5% or less, equivalent to an average holding period of at least 20 years.
The Rydex fund costs between 1.6% and 2.3% annually, the most of any S&P 500 index fund, according to Morningstar. But it tends to underperform the market by a margin even slightly wider than its already distended expenses. In 2016, for instance, it lagged the market by nearly 0.4 percentage points more than its expenses. Extra trading costs money.
Ivy McLemore, a spokesman for Guggenheim Investments, which offers the Rydex funds, says the fund is used by — and most suitable for — short-term traders. It “has performed in line with expectations,” given its expenses, he says.
The word “index” is related to the Latin word for forefinger. Index funds are meant to be indicators. If you own one, it should passively track the performance of a broad basket of stocks, bonds or other assets — and its own returns should indicate, almost exactly, how the underlying investments performed.
If they don’t, something is wrong.
Source: The Wall Street Journal, http://on.wsj.com/2iLkbBf
For further reading:
Definitions of ACTIVE, INDEX, INDEX FUND, PORTFOLIO MANAGER, in Jason Zweig, The Devil’s Financial Dictionary
Chapter Eight, “Surprise,” in Jason Zweig, Your Money and Your Brain