Do You Own Mutual Funds – Just Beware

This is only for people who own mutual funds in a taxable account. This year some people will get clobbered with a huge tax bill and our mutual fund is losing money. They call it adding insult to injury. If you own ETF’s instead, you don’t have this problem.

So how does this happen? It’s almost a perfect story, one you won’t like. Many mutual funds had substantial gains earlier this year, then the market started to turn south and a massive number of people sold. How do we know this, well if the mutual fund price drops 25-30% like the rest of the market, then a massive number of people sold!

The way mutual funds are designed, if people sell the fund the fund must sell the individual stocks. Let’s say it’s a US growth fund and the fund holds Facebook (META) as a major holding. You sell the fund, they in turn sell Facebook.

This year is unique, there is a huge outflow from growth mutual funds, the remaining shareholders will have to divide up the 2022 capital gains. How do you know if your fund might have this issue? Just check their turn-over ratio.

Here is an example, SHRAX, ClearBridge Aggressive Growth fund. It has an estimated $500M outflow, has lost 22% YTD. This fund has a PCGE of 87%, “potential capital gains exposure” (Barron’s).

Just to understand the math, let’s say a fund has $1M in capital gains for 2022 and there are 1,000 investors, each investor would get a 1099 – Capital Gains for $1,000. Now if so many people sell that there are only 500 shareholders, each will now get a $2,000 capital gains. You get the idea, it’s a “snowballing” effect.

What should you do:

1. Check any mutual fund in a taxable account, what will the annual distribution be? You can call the fund.
2. If there are any pending capital gains SELL THE MUTUAL FUND IMMEDIATELY!
3. A better rule, don’t hold mutual funds in any taxable account! Switch to a similar fund in an ETF format. They are much more tax friendly.
4. You might be tempted to respond, you want that “distribution”, it’s extra money right? NO, WRONG. The day of the distribution, the value of the fund goes down in price by the exact amount of any distribution!

Why are ETF’s better in a taxable account? For one, they don’t have this capital gains issue. When you sell shares in an ETF, they don’t actually “sell” the underlying shares, they have transfer arrangements with what’s called “authorized participants”. These are just large institution market makers that can offload the gains, package them with losses in other shares and eliminate any taxes to you.

Years ago I started managing my mother’s taxable investment account and it was loaded high quality mutual funds. Every year she was getting a big tax bill that was unnecessary. Over a few years we transitioned to ETF’s and the tax bills went away.