An Update on Colbie and a Taxing Conversation

Colbie Fall 2015-1


Todays post is written by SAGEbroadview Principal, Larry Annello.

A few months ago, I introduced our adorable puppy Colbie to the SAGEbroadview community. While our affection for her has grown with her paw size, Colbie is lucky that she is so darn cute, given her talent for sniffing out trouble. This reminds me of one way that investing does NOT parallel our beguiling girl: During turbulent markets, mutual fund investors can face ugly returns, and be bitten by undesirable, taxable capital gains.

We know this seems counterintuitive. If a fund in which you’re invested has declined in value, it seems you should at least be safe from having to pay capital gains taxes on it. Unfortunately, there are two ways you can realize capital gains in your taxable accounts:

  1. If you sell a fund for more than you paid for it
  2. If the fund manager sells positions within a fund you hold for more than they paid for them

When the second scenario applies, especially if the positions had been enjoying an earlier run-up, the sales can generate underlying capital gains that fund managers must pass on to their shareholders. In other words, regardless of a fund’s recent underperformance – and in some cases, even because of it – you may be hit with an unpleasant tax bill on the same.

When (and Why) Fund Managers Trade

So, why would fund managers do this? There are a number of possibilities:

To meet redemptions from undisciplined investors – As a patient investor adhering to an evidence-based investment strategy, you may decide that a holding that has been recently underperforming is still appropriate for your long-term goals and risk tolerances. So you remain invested, despite the setback. But what if your fellow shareholders aren’t as disciplined, and they bail out in droves during a decline? If a fund manager faces massive redemptions, it may be forced to sell underlying positions to pay for the exodus in cash.

To engage in market-timing – Active fund managers may deliberately shift assets out of stocks and into cash, presuming they can predict when it’s best to be in or out of the market. An October 2016 Wall Street Journal article, “Beware of Tax Surprises Lurking in Mutual Funds” cited one such example: “Earlier this month, First Pacific Advisors said that as a result of a strategic shift, [aka, market-timing] its FPA Perennial U.S. Value Fund paid out capital gains of $39.67 per share this year, which equaled about 82% of the fund’s net asset value at the time of the announcement.” Ouch.

To track an index – When an index such as the S&P 500 is reconstituted (adding, dropping or re-ranking the stocks it’s tracking), index funds following it may need to do the same, regardless of market conditions at the time.

To adhere to a strategy – Similarly, a fund’s prospectus (think of it as the fund’s playbook), describes the fund’s strategy and obligations. A well-managed small-company stock fund, for example, really should remain exposed to mostly small-company stocks, regardless of near-term performance in that asset class. As market conditions shift, fund managers may need to place trades to remain true to their structured action plan, so that you can remain true to yours.

In short, during good times and bad, there are valid and less-valid reasons that fund managers may need to pass taxable capital gains on to its shareholders. If you’ve participated in those gains during the long haul, it may help to think of them as a price paid for receiving them. As financial columnist Larry Swedroe has wryly observed, “[T]he only thing worse than having to pay taxes is to not have to pay them” (because you’ve got no gains to begin with).

You, Your Fund Manager and Your Taxable Investments

So what can investors do to minimize taxes due from fund managers’ capital gain distributions?

First, we want to emphasize that we still believe that mutual funds remain among the most efficient ways to participate in the market’s returns while its risks. We also do not recommend you join the masses by blindly fleeing bad news in an attempt to bypass the distributions. As we suggested in our first Colbie post, trying to time the market is likely a recipe for much greater harm. That said, here are a number of tax-wise moves you can make.

  • Asset location – Because you don’t have to pay taxes on annual distributions made by funds held in your tax-sheltered accounts, try to place your least tax-efficient holdings in your tax-sheltered accounts.
  • Evidence-based fund management – Seek fund managers who adhere to evidence-based investment strategies and who encourage other shareholders to do the same. That way, there’s less likely to be damage done by your fellow investors losing faith and forcing redemptions at all the wrong times. Here’s an insightful video featuring Dimensional Fund Advisors’ David Butler discussing the importance of “Staying in the Market.”
  • Tax-loss harvesting – Sometimes there are opportunities to engage in tax-loss harvesting during market downturns. When tax-loss harvesting otherwise makes sense for your investment plans, you may be able to offset any taxable gains with these losses.
  • Tax-managed funds – Some fund companies offer traditional and tax-managed versions of their funds, respectively tilted toward higher expected returns or higher tax efficiencies. All else being equal, we usually prefer the tax-managed versions for taxable accounts.
  • Evidence-based investing – Don’t forget to embrace a buy, hold and rebalance approach yourself, so you minimize your own taxable trading activities. Also, if you’re frequently jumping in and out of funds, you increase the odds of incurring a taxable distribution, even though you weren’t around to receive the returns upon which it is based.

Last but not least, it can be money well spent to work with an adviser who is experienced at implementing these and other tax-wise investment strategies. Because there’s nothing cute about paying more taxes than you need to.

Sage Serendipity:  ugly dogSo we all know Colbie can win the most adorable puppy award hands down. But let’s give some love to the Quasi Modo’s and Icky’s of the world who were part of this past summer’s Ugliest Dog Contest at the Sonoma-Marin Fair in Petaluma, California. writes “the contest aims to encourage adoption of dogs regardless of their physical shortcomings.”  There is a sort of undeniable swagger to these pooches!


Sheri Iannetta Cupo, CFP®, Founding Partner (Retired) & Director
[email protected]

SAGEbroadview Wealth Management is a Fee Only firm offering ongoing financial planning and portfolio management, with tax planning woven carefully throughout our services. We work virtually across the country, with offices in Farmington, CT, Morristown, NJ, and Burlington, MA.