Even when returns look good, actively managed mutual funds can’t catch a break from the popularity of passive investments. This time it's taxes.
If you invest in a mutual fund you probably know that you can expect to owe capital gains tax when you sell your shares and reap a profit. What you may not know is that you can also be on the hook for a tax bill even in years when you don't sell fund shares.
That's because Uncle Sam makes mutual fund shareholders pay up not just on their own gains, but on trading profits funds themselves earn each year. Funds typically distribute these profits to fund holders at the end of each year. While many fundholders choose to have the proceeds of the distributions automatically re-invested in the funds, this doesn't get them off the hook for paying taxes. (One piece of good news: Paying now for your share of your fund's profits will eventually lower what you owe when you sell your fund shares later on.)
Of course, capital gains — and the resulting tax bills — tend to be higher in years when the market is up, as it has been by nearly 25% in 2019. But, according to fund researcher Morningstar, another factor may also be at play: Index funds.
That's because while actively managed mutual funds always trade when portfolio managers want to move out of one stock and into another, recently some have also been forced to sell shares to raise money to pay departing fund shareholders who are moving their investments over to index funds. Over the past year through October, active large-cap stock funds lost $204 billion, according to Morningstar, as passive investments, like index funds, gained $222 billion.
"Forced selling can compel management to sell appreciated positions," Christine Benz, Morningstar’s director of personal finance wrote recently. "Those distributions in turn are made to a reduced group of shareholders. That's where big capital gains distributions come in."
While the number of large funds providing distributions of at least 10% of the value of their assets has declined from 2018 highs, Benz found that investors should still expect “many growth-oriented mutual funds dishing out sizable payouts.”
Here are some distributions you can expect from some notable fund families.
Vanguard’s Closed Funds Get Hit Hard
Vanguard Capital Opportunity (VHCOX), Vanguard Primecap (VPMCX) and Vanguard Primecap Core (VPCCX) will all distribute 6% of the value of their assets and all three funds are currently limited or closed to new investors.
The fund with the largest distribution within the Vanguard family, though, comes from the Vanguard Mid-Cap Growth (VMGRX). It expects to distribute 13% of its assets, while seeing a total return of 29% for the year.
Fidelity’s Distributions Hold Tight
Fidelity’s funds aren't expected to make as large of distributions this year, especially among some of the most high profile names, according to Benz. For example, Fidelity Low-Priced Stock (FLPSX), which has $29 billion in assets and returned 19.5% in 2019, won’t need to make a distribution.
The most noteworthy distribution comes from Fidelity Magellan (FMAGX). It’s undergoing a manager switch, one that officially goes into effect at the start of 2020. It’s not unusual for investors to move away as a fund adjusts to a new regime. As a result, the fund will pay out 12% of the value of its assets.
Invesco Hit By Oppenheimer Purchase
The fund family with some of the largest distributions comes from Invesco. You can blame its purchase of Oppenheimer Funds, which finalized in the spring, for the outlying results. Invesco has multiple funds that will distribute 20% or more of the NAV to investors, due to a reshuffling of managers, says Benz.
The $4 billion Invesco Oppenheimer Capital Appreciation fund (OPTFX) underwent a management change shortly after the merger. This led to a reshuffling of its portfolio, which could have contributed to the estimated 21% distribution it will send investors this year.
Invesco Mid Cap Growth (VGRAX) and Invesco Oppenheimer Value (CGRWX) both experienced a similar management change, and will distribute 20% of NAV as a result.
In an email, Invesco said its fund managers always act in the best interests of investors, taking a long-term approach to investment management.