Is there anything more unpleasant than paying taxes on a money-losing investment? That’s the prospect some mutual fund shareholders will face this year.
At year end, mutual funds distribute gains they have realized during the year, even if investors bought the fund after the gains were made. These gains are taxable. Since 2021 was a strong year, with the stock market up almost 30%, many fund portfolios hold appreciated stock with embedded gains despite being down in 2022.
“I think investors will be surprised they’re getting tax bills for funds that have lost money during the year,” says Todd Rosenbluth, head of research at financial analytics firm VettaFi. “That is likely to cause them to have disloyalty toward some of their funds and shift toward the more tax-efficient ETF structure, and this will cause a snowball effect.”
In contrast to mutual funds, exchange-traded funds can unload appreciated stock without triggering a taxable distribution. ETFs have what are called authorized participants—institutional market makers who receive baskets of appreciated stock when ETF investors redeem their shares—so ETF managers don’t have to sell shares and realize capital gains.
Historically, active mutual funds with managers who trade a lot—and hence have high “turnover ratios”—are the most tax-inefficient, as they often sell appreciated stock, forcing gains distributions. But many low-turnover funds currently have large built-in gains from years of managers buying and holding their favorite stocks. And many funds are facing outflows in a down market, which can force their managers to sell appreciated stocks.
Being hit with a tax bill in a down year could cause the snowball effect that Rosenbluth describes. Investors selling mutual funds causes more gains to be distributed, which begets more selling by investors. Russel Kinnel, Morningstar’s director of manager research, has dubbed the phenomenon “Flowmageddon.” He explains: “Active funds have been in outflows for the most part for the last decade. The fear here is if a bear market were to trigger bigger outflows.”
It’s Pay-Up Time
These 10 funds have lost investors money this year, but still carry significant taxable gains.
|Fund / Ticker||Potential Capital Gains Exposure*||Annual Report Date||Est. 2022 Fund Flows (mil)**||AUM (bil)||YTD Return||Turnover Ratio|
|ClearBridge Aggressive Growth / SHRAX||87.6%||8/31/2021||-$517||$4.5||-22.3%||8.0%|
|Baron Growth / BGRFX||84.3||9/30/2021||-442||6.8||-25.7||1.4|
|Baron Partners / BPTRX||83.6||12/31/2021||-42||6.6||-18.4||9.1|
|Franklin Growth / FKGRX||80.3||9/30/2021||-1,390||16.1||-24.1||6.0|
|BNY Mellon S&P 500 Index / PEOPX||79.6||10/31/2021||-126||2.0||-17.5||3.3|
|DFA U.S. Large Company / DFUSX||79.3||10/31/2021||-235||10.0||-17.3||4.0|
|Fidelity Growth Company / FDGRX||79.3||11/30/2021||-4,446||43.6||-29.1||16.0|
|American Century Ultra / TWCUX||77.3||10/31/2021||-131||16.2||-26.2||8.0|
|Columbia Large Cap Index / NINDX||76.3||2/28/2022||-169||2.7||-17.4||2.0|
|John Hancock Blue Chip Growth / JHBCX||75.7||8/31/2021||-202||3.5||-31.1||33.0|
Note: *PCGE data are as of the latest annual report. **Fund flow estimates are as of Aug. 31, YTD returns through Sept. 19.
Source: Morningstar Direct
Yet Kinnel isn’t predicting major tax bills this year. Since the bear market started early in 2022, he thinks many funds have had the time to harvest some capital losses in the year’s first few months to counteract potential gains distributions.
Still, there will be some surprises this year as the Flowmageddon continues. Investors could see distributions in funds that have outsize potential capital-gains exposure, or PCGE—a Morningstar stat that calculates the percentage of a fund’s assets that are taxable gains.
Want to know if you’re at risk of a tax bill? You can find a fund’s PCGE by clicking on the “Price” tab of its Morningstar report under “Taxes.” One caveat: PCGE is calculated as of the fund’s latest annual report, which often creates a time lag. Yet it provides a good starting-off point before delving deeper into the fund’s more recent semiannual reports for gains exposure.
Ranking large retail funds that have high PCGEs and outflows this year produces some interesting distribution candidates. ClearBridge Aggressive Growth (ticker: SHRAX) had a PCGE of 87.6% as of its latest annual report, dated Aug. 31, 2021. To get more recent info, look at the fund’s “statement of assets and liabilities” in its latest semiannual report, dated Feb. 28, 2022. There, you can see its “total distributable earnings” of $3.95 billion above its $5.71 billion in “total net assets.” Divide the former into the latter and you have a still-high 69% potential capital gains.
ClearBridge Aggressive Growth had $517 million in estimated outflows through Aug. 31. Worse, the fund’s longtime lead manager, Richie Freeman, stepped down last year. “A manager change can result in a high tax bill for investors, as some investors will rotate to another strategy because they were loyal to the manager who’s no longer there,” Rosenbluth says. “Also, the new manager often makes portfolio changes, and that can have a triggering effect that causes a tax burden.”
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 8% turnover ratio.
The Baron Partners fund (BPTRX), with an 83.6% PCGE as of Dec. 31, 2021, is also worrisome. Almost half of its portfolio is in one stock, Tesla (TSLA), which in the fund’s June 30 semiannual report had a cost basis of $183.5 million and an appreciated value of $2.73 billion. The $6.6 billion fund has seen only $42 million in outflows in 2022, but if it gets worse, Tesla gains will almost certainly be realized. Baron didn’t respond to a request for 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 numerous index mutual funds with high built-in gains. Normally tax-efficient, they pose unusual risks now that investors are selling them to buy cheaper ETFs. If investors already have a loss from a high-PCGE fund from 2022’s turbulence, they are probably better off selling it now and writing off the tax loss instead of getting hit with capital-gains taxes on top of their loss at year end.