Why You Might Have To Pay Capital Gains Taxes Even If Your Mutual Funds Are Down

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Nearly half of the Baron Partners fund’s portfolio is made up of a single stock: Tesla.

Taehoon Kim/Bloomberg

Is there anything worse than paying taxes on an investment that loses money? That’s the prospect some mutual fund shareholders will face this year.

At the end of the year, mutual funds distribute the gains they made during the year, even if investors bought the fund after the gains were made. These gains are taxable. Given that 2021 has been a strong year, with the stock market up almost 30%, many fund portfolios hold stocks that have appreciated with price gains built in despite a decline in 2022.

“I think investors will be surprised to receive tax bills for funds that lost money during the year,” says Todd Rosenbluth, head of research at VettaFi, a financial analytics firm. “This will likely cause them to become disloyal to some of their funds and move to the more tax-efficient ETF structure, which will cause a snowball effect.”

Unlike mutual funds, exchange-traded funds can offload appreciated stocks without triggering a taxable distribution. ETFs have what are called authorized participants – institutional market makers who receive baskets of appreciated shares when ETF investors redeem their shares – so ETF managers do not have to sell shares and to realize capital gains.

Historically, active mutual funds with managers who trade a lot – and therefore have high “turnover ratios” – are the most tax-inefficient, as they often sell appreciated stocks, forcing earnings distributions. But many low-turnover funds currently have big embedded gains after years of managers buying and holding their favorite stocks. And many funds face cash outflows in a bear market, which can force their managers to sell popular stocks.

Being hit with a tax bill in a tough year could cause the snowball effect described by Rosenbluth. Investors who sell mutual funds result in more earnings being distributed, which leads to more sales by investors. Russel Kinnel, director of manager research at Morningstar, dubbed the phenomenon “Flowmageddon.” He explains: “Active funds have mostly been in exits over the past decade. The fear here is that a bear market will trigger larger capital outflows. »

Fund / Symbol Potential exposure to capital gains* Annual report date East. Flow of funds 2022 (millions)** AUM (bil) Cumulative return since the beginning of the year The turnover rate
ClearBridge/SHRAX Aggressive Growth 87.6% 08/31/2021 -$517 $4.5 -22.3% 8.0%
Baron Growth / BGRFX 84.3 09/30/2021 -442 6.8 -25.7 1.4
Partners Baron / BPTRX 83.6 31/12/2021 -42 6.6 -18.4 9.1
Franklin Growth / FKGRX 80.3 09/30/2021 -1,390 16.1 -24.1 6.0
BNY Mellon S&P 500 / PEOPX Index 79.6 31/10/2021 -126 2.0 -17.5 3.3
DFA Large American Company / DFUSX 79.3 31/10/2021 -235 10.0 -17.3 4.0
Fidelity Growth Company / FDGRX 79.3 30/11/2021 -4,446 43.6 -29.1 16.0
American Century Ultra / TWCUX 77.3 31/10/2021 -131 16.2 -26.2 8.0
Columbia Large Cap Index / NINDX 76.3 02/28/2022 -169 2.7 -17.4 2.0
Blue Chip Growth John Hancock/JHBCX 75.7 08/31/2021 -202 3.5 -31.1 33.0

Note: *PCGE data is from the latest annual report. ** Funds flow estimates are as of August 31, year-to-date returns through September 19.

Source: Morningstar Direct

Still, Kinnel does not predict large tax bills this year. Since the bear market began in early 2022, he believes many funds have had time to reap capital losses in the early months of the year to counter potential gain distributions.

Still, there will be a few surprises this year as Flowmageddon continues. Investors could see distributions in funds that have outsized potential exposure to capital gains, or PCGE, a Morningstar statistic that calculates the percentage of a fund’s assets that are taxable gains.

Want to know if you risk a tax bill? You can find a fund’s PCGE by clicking on the “Pricing” tab of its Morningstar report under “Taxes.” Please note that the PCGE is calculated from the fund’s last annual report, which often creates a time lag. Still, it provides a good starting point before digging deeper into the fund’s most recent semi-annual reports for gain exposure.

The ranking of large retail funds that have high PCGEs and outflows this year are producing attractive candidates for distribution.

ClearBridge Dynamic Growth

(ticker: SHRAX) had a PCGE of 87.6% in its latest annual report, dated August 31, 2021. For more recent information, see the fund’s “statement of assets and liabilities” in its latest semi-annual report , dated February. December 28, 2022. There you can see his “total distributable income” of $3.95 billion above his “total net assets” of $5.71 billion. Divide the first into the second and you have a still high capital gains potential of 69%.

ClearBridge Aggressive Growth had estimated outflows of $517 million through August 31. Worse still, the fund’s longtime lead manager, Richie Freeman, resigned last year. “A change in manager can result in a high tax bill for investors, as some investors will switch to another strategy because they were loyal to the manager who is no longer there,” Rosenbluth says. “Also, the new manager often makes portfolio changes, and that can have a trigger effect that results in a tax charge.”

A spokeswoman for ClearBridge parent company Franklin Templeton declined to comment on the likelihood of a distribution this year. The fund is down 22% year-to-date and has a low turnover rate of 8%.


Partner Barons

(BPTRX), with a PCGE of 83.6% as of December 31, 2021, is also worrying. Nearly half of its portfolio is made up of a single stock,

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(TSLA), which, in the fund’s June 30 semi-annual report, had a base cost of $183.5 million and an appreciated value of $2.73 billion. The $6.6 billion fund only saw $42 million in outflows in 2022, but if things get worse, Tesla’s gains will almost certainly be realized. Baron declined to comment. The fund is down 18.4% in 2022, but as of June 30, it still had $4.4 billion in distributable earnings.

There are also many index mutual funds with high embedded gains. Normally tax-efficient, they come with unusual risks now that investors are selling them to buy cheaper ETFs. If investors have already suffered a loss on a high PCGE fund due to the turmoil of 2022, they would probably be better off selling it now and reversing the tax loss instead of incurring capital gains taxes on top of that. of their loss at the end of the year.

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