Posted by on Dec 29, 2014 in Blog, Columns, Featured |

By Jason Zweig | 11:24 am ET  Dec. 26, 2014

Image Credit: Christophe Vorlet

To the insult of chronic underperformance, mutual funds are adding the injury of unusually high taxes.

 The week of Dec. 15, dozens of mutual funds paid out taxable gains to their shareholders—even as the worst year of fund returns relative to market averages in modern history drew to a close.

As of Dec. 19, more than 79% of U.S. stock funds had failed to beat their market benchmarks for the year, compared with the average of 59% over the previous 25 years, according to investment-research firm Morningstar. As if that weren’t bad enough, investors in many underperforming funds will find themselves owing whopping tax bills without having sold a share.

When they sell their holdings, mutual funds have to pay out any profits as taxable capital gains unless they can offset them against losses. After nearly six years of a raging bull market, most funds have no big losses left.

So, even after underperforming the market badly this year, funds are doling out startlingly big tax bills for their investors. (If you own a fund in a tax-deferred retirement account, you won’t owe current taxes on these payouts.)

Consider the Calamos Growth Fund. Exactly six days before Christmas, the $3.5 billion fund distributed $10.13 per share in long-term capital gains to its investors. Based on its net asset value of $49.72 the previous day, that was 20.4% of the portfolio’s value. Calamos Growth’s 8.3% return through that day was more than five percentage points worse than the S&P 500 and nearly two points behind the average large growth fund, according to Morningstar.

A Calamos spokeswoman said that in the interest of its clients, the firm seeks to produce long-term rather than short-term gains, which would be taxed at a higher rate.

Or take the $2.6 billion Janus Forty Fund, which also generated a market-lagging return of 8.3%. On Dec. 17, the fund’s S share class paid out $0.76 in short-term capital gains and $13.44 in long-term capital gains.

By my estimate, based on Janus’s disclosures and the highest federal tax brackets, a high-income shareholder with $10,000 in a taxable account would have received distributions of about $3,385 and incurred federal tax of about $830. A Janus spokesman said the number could be “a lot lower” depending on circumstances.

“These [long-term capital] gains are mostly the result of individual holdings that had been in our portfolios for a number of years,” the Janus spokesman said, adding that the firm sold many of the stocks because they had risen in price beyond what its analysts felt they were worth.

Mutual funds are generally required by tax law to pay out all profits they realize on the sale of their holdings. An investor outside a retirement account is typically liable for taxes on any gains the fund distributed during the tax year—even if he or she never sold a share of the fund.

Gains can be triggered when a fund changes strategy or portfolio managers, forcing a sale of many of its holdings. When a company that a fund owns is taken over in a merger or acquisition, or when a stock gets too big for a fund’s style, the manager may have no choice but to sell. Also, the manager may have to liquidate securities to cash out investors who leave a fund; that can trigger taxable gains for those who remain behind.

Although no industry data source tabulates capital-gain distributions until after they are all paid out, analysts say they expect this year to be one of the worst on record. Stocks are up, and the exodus of investors from many funds is forcing managers to sell holdings at a gain.

“I can’t think of a year that compares with this one historically,” says Mark Wilson, chief investment officer at the Tarbox Group, a financial-advisory firm in Newport Beach, Calif., that manages $450 million.

In his spare time, Mr. Wilson runs a website,, that tracks taxable distributions by funds. He estimates that at least 500 funds have distributed 10% or more of their assets as taxable gains this year; at least 64 have distributed more than 20%.

It wasn’t always this way. After stocks fell by more than 50% during the financial crisis, many portfolio managers sold holdings at deep losses. Later, when they sold winners, the managers were able to offset those profits against the earlier losses, minimizing or even eliminating capital-gains tax bills for their investors.

“Fund managers had been able to be fairly indiscriminate in selling, because those losses gave them flexibility for years,” says David Snowball, publisher of Mutual Fund Observer, an online publication about fund investing. But now, the tax losses have been used up and can no longer be used to shelter any gains.

Dan Newhall, a principal in the portfolio-review department at fund giant Vanguard Group, says this year’s distributions are a reminder that actively managed funds run by stock pickers seeking to beat the market are “generally less tax-efficient than index funds and exchange-traded funds.”

One of his firm’s funds, Vanguard Explorer, paid out approximately 13% of its value in long-term gains on Dec. 18. But, estimates Mr. Newhall, at least 85% of Explorer’s assets are held in tax-deferred accounts, where investors won’t owe current taxes on those gains.

In general, a capital-gains distribution much above 10% of your account value is “a signal that something bad is going on,” says Mr. Snowball. He adds, “It entitles investors to ask, ‘Why am I entrusting my money to these people?’”

Good question. If the mutual-fund industry isn’t to lose the faith of the investing public entirely, it needs to stop clobbering its customers with monstrous tax bills.


Source: The Wall Street Journal