How Advisors Can Help Clients Avoid Thorny Capital Gains Distributions

With just over a month left in 2022, many clients are likely looking forward to turning the calendar to 2023 in hopes the new year will bring better outcomes for stocks and bonds.

Of course, that remains to be seen, but the desire to move past 2022 is understandable. After all, this will go down as the rare year in which bonds declined alongside equities, explaining why attitudes and outcomes are currently somber. Unfortunately, with the fourth quarter here, challenges remain for investors in the form of capital gains distributions from actively managed mutual funds. Here’s a simple explanation of capital gains distributions, courtesy of Investopedia.

“A capital gains distribution is a payment by a mutual fund or an exchange-traded fund (ETF) of a portion of the proceeds from the fund's sales of stocks and other assets from within its portfolio. It is the investor's pro-rata share of the proceeds from the fund's transactions,” according to Investopedia. “It is not, however, a share of the fund's overall profit. The fund may gain or lose money over the course of a year, and your balance will rise or fall accordingly. But if the fund gained from the sale of any of its stocks during that year, it will make capital gains distributions to its shareholders.”

A quick housekeeping item. Some ETFs do subject investors to cap gains, but the percentage of such funds doing so is paltry compared to traditional actively managed mutual funds. Take it from someone that’s covered ETFs for about over a decade, ETF issuers love to brag about their lack of capital gains exposure and this the time of years for that boasting.

It’s a hypothetical example, but it’s entirely possible that an ETF issuer with 100 funds is preparing to issue a press release noting that just three or four of its funds will subject investors to cap gains this year. That’s an excellent percentage relative to any number of active mutual fund issuers.

Potentially Ugly Cap Gains Situations with Mutual Funds

Due in part to the aforementioned slumps by stocks and bonds this year, the 2022 capital gains situation could be a bitter pill for many clients to digest.

“From a quick survey of a few major fund companies, it’s clear that capital gains distributions can be quite material this year. For example, some American Funds offerings are estimating year-end distributions as high as a range of 6% to 9% of net asset value,” notes Morningstar’s Sheryl Rowling. “JP Morgan estimates go as high as 12% to 23% of NAV for some funds. BNY Mellon has issued estimates for some funds to be 12% to 17%. T. Rowe Price estimated year-end distributions of 10% to more than 20% of NAV for some funds. You get the idea. Clients won’t want to experience this unwanted surprise.”

Those are some big fund issuers mentioned there – ones advisors likely allocate to and ones that clients are likely comfortable and familiar with. Fortunately, there are effective avenues for avoiding capital gains distributions. For example, if the client is exposed to an actively managed large-cap fund that is going to deliver cap gains on, say, Dec. 20, the advisor can more the client out of that fund into a passive ETF equivalent.

“Once you’ve identified the problem funds, you’ll need to find alternative positions with lower distributions, so your clients will continue to be fully invested in the interim,” adds Rowling. “Investing in a similar position that has little to no estimated distributions will enable clients to maintain their investment strategies while avoiding the phantom income.”

Some Legwork Involved

Avoiding capital gains is a good news/bad news proposition. The bad news is it requires some legwork on behalf of advisors. The good news is the work is worth it and isn’t overly taxing. A lot of it revolves around how an advisor defines “material,” which is must be defined in both dollar terms and percentages.

“Let’s say an advisor sets materiality at $1,000 and 0.50%. Assume ABC Small-Cap Fund is distributing long-term capital gains equal to 10% of NAV. Portfolio allocations typically contain 5% small cap,” concludes Rowling. “Capital gains distribution avoidance for the ABC fund would only be material, from a dollar standpoint, for portfolios in excess of $1 million ($1 million times 5% times 10% times 20% capital gains rate equals about $1,000). However, a $1,000 tax savings on a $1 million portfolio is 0.10% of the portfolio. Thus, it is impossible to meet both materiality thresholds, so the advisor would not run calculations on this fund.”

Of course, it’s on advisors regarding what asset they decide to move into after dropping the capital gains offender, but they can offer clients added benefit by moving to index funds or ETFs. Not only does that dramatically reduce the possibility of capital gains, but the lower expense ratios are material to long-term investors.