City Different Investments Blog

The Problem With Mutual Fund Capital Gains, And What To Do About It

Written by City Different Investments | Apr 13, 2022 9:06:02 PM

2021 tax bills are due in just a few days, and we’re hearing some uncomfortable groans from mutual fund investors. Here’s why: A combination of strong market gains and high trading activity led to record capital gains distributions, and that means historic capital gains taxes. Below, we’ll explain the relationship between mutual fund performance and capital gains tax, how that relationship affects investors holding assets in taxable funds, and one way to address these issues in the future, through separately managed accounts.

Mutual funds and capital gains

Most folks reading this know that mutual funds pool investor capital to purchase stocks, bonds and other securities. If the fund sells an asset that has grown in value since it was purchased, the proceeds of the sale are distributed to the fund’s owners. That’s a capital gain distribution, and it’s considered a taxable event by the IRS. In that sense, mutual fund holdings are similar to any tradable asset, in that it triggers a tax on any realized gains.

When funds make distributions, it is common for the proceeds to automatically reinvest back into the fund. That can make capital gains taxes feel especially frustrating—it’s not like you sold your own shares. In fact, some investors might not even be aware that they owe capital gains tax until they see IRS form 1099-DIV arrive in the mail.

So far so simple—ceteris paribus, if a mutual fund you own increases in value, and its assets are traded, you’re likely paying capital gains tax.

What’s happening this year

In 2021, mutual funds were generally up, and for many investors, this was good news. But we also saw capital gains distributions run in the 10 to 15% range at many large funds. A few cracked 20%, and some were above 30%. For many investors, these historically large capital gains distributions will yield historically large capital gains tax bills.

But as some investors are also now realizing, mutual fund capital gains distributions aren’t only triggered when fund managers decide to trade fund assets. (Good fund managers will try to minimize trades in up years, in order to minimize distributions.) Their investors can take actions that create distributions, too.

Say a big investor in a fund you own decides to leave, something that happened a lot in 2021, as investors left mutual funds en masse for exchange-traded funds. The capital gains created by sales to meet redemptions can create taxable distributions. Even if the fund loses money overall on the year, you might find yourself in a situation where you haven’t made a single trade, your fund is down on net, and you still owe capital gains tax.

There’s an alternative

We’re not here to knock mutual funds. They give many investors an opportunity to put money under active and professional management, sparing the risk and hassle of choosing stocks themselves. Mutual funds are often a good choice.

Alternatively, separately managed accounts (SMAs) provide their own unique advantages and help to avoid the worst problems created by capital gains distributions. Unlike mutual funds, where investor money is pooled, separately managed accounts keep each investor’s assets siloed. An investor in an SMA can own the same assets as a leading mutual fund, but those assets live in their own account. A decision to trade an asset in one account has no bearing on other investor accounts.

That structure gives SMAs several tax advantages over mutual funds. First, SMAs give investors more control over their own individual investments. An investor in an SMA can consider their likely tax burden early in the investment process. Second, as the year goes on, investors can balance their winning assets against their losing assets, reducing (or maybe eliminating) capital gains liabilities that are unavoidable with mutual funds. And third, an SMA investor won’t ever pay capital gains tax on another investor’s decision to exit. After all, in an SMA, there’s only one investor.

Many investors are reeling this week as they face down large unexpected capital gains tax bills. We believe an SMA-based approach is one of the best ways to avoid this issue.

 

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