(PUB) Investing 2016

August 2016 Vol. 24 No. 12

FundInvestor Research and recommendatio s for the s riou fund investo

SM

Funds Facing a Tax Challenge

in taxes as a percentage of returns. So, investors in the top tax bracket who own funds in taxable accounts paid out a big chunk of recent returns in taxes because we are a long way into a market rally. It’s a little worse than that for most investors. If I limit my screen to funds with more than $1 billion in assets— because that reflects the funds most investors own—the PCGE goes up to 19% , although the three- year tax-cost ratio is about the same. You can find a fund’s tax-cost ratio in the FundInvestor 500 tab of mfi.morningstar.com. Slide the bar to the right to see that column. To find a fund’s PCGE , click its name and pull up the one-page report. The PCGE is on the left-hand side of the report near the middle of the page, just below the tax section. Now, let’s add a third data point: flows. Many U.S. equity funds have been hit with sizable outflows, which means they have to sell off a good chunk of their portfolios. This makes it much tougher for the manager to keep the tax bill low. I looked for funds with an unhappy convergence of significant PCGE and outflows in order to flag some funds likely to make a big payout. Typically, these payouts come in December, but occasionally funds will make them early in order to get them out of the way and remove the incentive for investors to flee. Whether you should actually sell to avoid the capital gains payout depends on your cost basis. If you bought within the past couple of years, you probably would do all right by selling. However, if you’ve held for a decade or more, you probably would end up with a big tax bill either way, so ask your accountant. (Brokerages are now required to track your cost basis but only from the

RusselKinnel, Director of ManagerResearch and Editor

Fund Reports 4 Loomis Sayles Global Equity & Inc Metropolitan West High Yield Bond T. Rowe Price Real Estate USAA World Growth

U.S. stock indexes are hitting record highs while Europe remains in a slump. That tells me that we’re in for some significant capital gains distributions for U.S. equity funds, but it might not be that bad elsewhere. The trend is confirmed by data on mutual fund taxes. Potential capital gains exposure has been on the rise. Once a year, funds report how much unrealized capital gains are in their portfolios. We then adjust that figure each month for appreciation or depreciation. The figure tells you approximately what the fund might have to pay out as a capital gains distribution if it sold every holding. Of course, it won’t sell everything, so it’s quite rare for a fund’s actual capital gains payout to equal its potential capital gains exposure. In addition, we’ve had two mini-sell-offs this year that could mean some funds realized losses to offset gains or at least sold at less of a profit. When PCGE rises, tax payouts rise. You can see that from the graph, which shows that the tax-cost ratio trend follows PCGE up and down. It makes perfect sense that rising unrealized gains will lead to rising realized gains. After all, most equity funds have turnover rates greater than 50% , implying that quite a few names will be traded in the course of a year. Today, the average equity fund has a PCGE of 11 . 2% of assets and a three-year tax-cost ratio of 1 . 92% . Think of that tax-cost ratio as an expense ratio for taxes. It assumes that investors are in the highest tax bracket and estimates how much per year investors paid out

Morningstar Research 8 Do Objectives-Based Funds Deliver?

The Contrarian 10 Defensive Funds for Offensive Times

Red Flags

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Funds That Lack the Protection of Moats

Market Overview

12

Leaders & Laggards

13

Manager Changes and News

14

Portfolio Matters

16

7 Retirement Blindspots to Watch Out For

Tracking Morningstar

18

Analyst Ratings

Income Strategist

20

Bank-Loan Funds Losing Appeal

Changes to the 500

22

FundInvestor 500 Spotlight

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Follow Russ on Twitter @RussKinnel

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