(PUB) Investing 2015

11

November 2015

Morningstar FundInvestor

Tax Season Is Getting Tough Red Flags | Michael Rawson

Neutral-rated Buffalo Small Cap BUFSX has a potential capital gains exposure of 75% of assets. Two portfolio managers, Kent Gasaway and John Bichelmeyer, stepped down from the fund this year, and outflows have cut fund assets in half through the first nine months of 2015 . The fund issued a capital gain equivalent to 10% of NAV in 2014 . Bronze-rated Dreyfus Appreciation DGAGX has suffered $2 . 3 billion in outflows this year, amid lackluster performance, cutting the fund’s asset base in half. The fund distributed a small capital gain in 2014 , but imbedded gains still represent about 74% of the fund’s NAV . The fund likely trimmed many appreciated stocks to meet outflows, making a larger distribution likely this year. Another fund that’s been wracked by outflows is Neutral-rated Columbia Acorn ACRNX . The fund has underperformed and went through several manager changes this year. Through the first nine months of the year, investors redeemed a net $6 . 5 billion, leaving the fund with just under $10 billion in assets. Remaining investors face a potential capital gains exposure of 73% . The fund issued a capital gains distribution in June 2015 equivalent to 5% of the fund’s NAV , but more may be on the way. Kalmar Growth-with-Value Small Cap KGSCX has lagged the Russell 2000 Growth Index by 5 percentage points during the past three years. Investors seem to have grown impatient, and the fund has been crushed by outflows this year, cutting assets in half. With potential capital gains exposure of 39% , the fund may be unable to avoid issuing a capital gains distribution, as it did in 2014 . It is usually not a good idea to sell a great fund in an attempt to avoid a capital gains distribution, as you will trigger your own capital gain. But it makes sense to delay the purchase of a fund that is about to make a distribution or to make the purchase in a tax- sheltered account. K Contact Michael Rawson at michael.rawson@morningstar.com

After a 6 . 5 -year bull market, a fund’s long-term winners can carry a bite. When funds sell stocks that have appreciated, they have to make a taxable capital gains distribution based on the total net value of realized capital gains as of Oct. 31 of each year. (Russ Kinnel high- lighted the growing problem of capital gains payouts in the April issue of FundInvestor .) Big fund companies typically come out with their first es- timates for year-end distributions in early November. This information is usually found within their websites, by searching for taxes or distributions. They put out final estimates a few weeks later, but the numbers rarely differ. Payouts typically are made in the last week of the year. Some funds have already made their payouts. For example, in early October, FPA US Value FPPFX , with a Morningstar Analyst Rating of Neutral, issued a massive $39 . 67 -per-share capital gain amounting to 82% of the fund’s pre-distribution net asset value. The gain came after the fund got a new manager in June 2015 and he remodeled the portfolio’s mandate and holdings. To FPA ’s credit, it closed the fund when it an- nounced the transition and warned investors about the distribution. Morningstar estimates a fund’s potential capital gains exposure based on its net unrealized capital appreciation and net realized gains included in the fund’s annual report. We also factor in recent price appreciation, less any capital gains distributions since the annual report. The result is scaled by current assets to lead to a likely payout figure that’s subject to taxes. Fund companies usually begin posting capital gains distributions esti- mates to their websites in early December. Here we provide updates for several U.S. equity funds in the Morningstar 500 based on September 2015 data.

What is Red Flags? Red Flags is designed to alert you to funds’ hidden risks. Such risks can take many forms, including asset bloat, the departure of a solid manager, or a focus on an overhyped asset class. Not every fund featured in Red Flags is a sell, and in fact, some are good long-term holdings. But investors should be prepared for a potentially bumpier ride in the near future.