American rock icon Tom Petty had a huge hit many years ago titled “I Won’t Back Down.”  Tom Petty died too soon in 2017 but the song lives on as a challenge for investors in 2022. It has been a difficult year with both stocks and bonds[i] posting double digit negative returns year to date. And for many taxable investors, events may unfold to add more salt to the investing wound with taxable capital gain distributions. Headwinds from stocks, bonds and taxes all come together to make it tough for investors not to flinch. It is time to stand your ground and not consider backing down.

Capital gains: What is the problem?

If a mutual fund has realized gains greater than realized losses during their fiscal year, they must distribute at least 98% of these gains to investors via the IRS Form 1099 early the next year. For taxable accounts, this can be a taxable event – even if the distribution is reinvested. The Department of Treasury wants their cut.

In years when the capital markets are positive, investors are often more understanding about having to pay tax because they feel like they made money for the year. But in years when the markets are negative, the idea of having to pay an income tax for an investment that lost money can be challenging.  While no one likes the idea of having to pay these investments taxes, it is harder to accept during down markets.

The last time U.S. equity markets were negative was in 2018 when U.S. stocks were down -5% for the year and the average U.S. equity mutual fund had a capital gain distribution of 11% of the fund’s Net Asset Value[ii]. What does that look like in dollars? Check out example below which assumes a starting investment amount of $1,053 and long-term capital gain tax rate of 15%.

You can see that a theoretical investment with the average market return (-5%) and average capital gain distribution (11% of NAV) lost an additional -1.6% of investment return due to the tax paid.  This example assumes all the distribution was Long-Term Capital Gain – not Short Term – and assumes a tax rate of 15%.  Both are somewhat conservative, and the resulting tax drag could be worse than conservatively shown.

This after-tax outcome is the definition of adding insult to injury. And 2022 is likely on pace (as of now) to be down more than 5%. Note the 11% distribution back in 2018 was the highest distribution percentage as of that time over the prior 10 years.²

How does that impact 2022?

Could 2022 be worse for distributions than 2018? There is no way to say for certain until we start seeing fund companies publish capital gain distribution estimates this fall, but there are a few things that lead one to think it won’t be daisies and unicorns for taxable distributions.

• Challenging year-to-date markets have put pressure on many funds with redemptions larger than purchases on the mutual fund. How does a fund meet these redemptions? If large enough, they start selling stocks or bonds to raise cash. At some point, this unproductive turnover can lead to capital gain realization.
• While year-to-date returns have been challenging, the longer terms numbers have been relatively attractive. The 10-year performance number for U.S. stocks ending August 2022 equals 12.8% annualized or 233% cumulative. Those returns can lead to many unrealized gains built up in a mutual fund. The above reference turnover can contribute to forced capital gain realizations and distributions.

Is this only an active management issue?

Not necessarily. Note that selling pressure on index funds or ETFs can lead to capital gain distributions as well. They are not immune. The Financial Times reported last year that 9% of ETFs offered by BlackRock, Vanguard and State Street had capital gain distributions from 2021[iii].

How does Frontier Asset Management address the challenge?

Frontier Asset Management is acutely aware of the challenges presented by mutual fund distributions. It is something we consider in our investment product evaluation process and monitor throughout the year. Taxes come into play in our Tax-Managed Strategies in a variety of ways:

1. The goal of our Tax-Managed Strategies is not avoidance of tax, but to maximize after-tax return.

Note: Minimizing taxes is not a financial goal. Frontier believes maximizing after-tax return better aligns with long-term financial goals (i.e., more after-tax money).

2. Our fund selection process uses tax efficiency and prior capital gain distributions as an input in selecting product for inclusion in our Tax-Managed Strategies.

3. We monitor mutual funds for the size and timing of their estimated capital gains – if any. Where appropriate, we will analyze the size of the distribution vs. any possible tax from selling out of a fund. A thoughtful analysis is especially important for this decision.

Note: Any capital asset held that appreciates in value, the owner will generally – at some time – owe a tax on that asset when sold or liquidated. One could hold the asset until death and provide heirs a step-up in basis, but this does not help for assets targeted for use during the investor’s lifetime.

4. We consider all active mutual funds / all index funds / all active ETFs / all passive ETFs in our fund selection process. This open architecture approach widens the universe of compelling after-tax investment options. We believe not being restricted to proprietary funds provides a competitive advantage.

5. Tax-loss harvesting: We have written previously about the ability to opportunistically sell a fund when down in an attempt to create a tax asset by “harvesting” the loss. When done successfully, this may reduce the impact of capital gain distributions. In the example above, an analysis would be done to see the value of potentially harvesting the loss (selling the fund) before the distribution vs. the tax bill. In this example, it would depend on the investor’s adjusted cost basis.

Getting ready for client conversations

As we move into the fall, I believe you will undoubtedly see many stories about the additional insult of taxable distributions added to the injury of experiencing negative returns. We’ve seen it happen in prior years.  Make sure you understand why this is happening and be able to explain to your clients what you are doing with your investment partners to be in front of these possible distributions. And remind them that avoiding a tax is not likely the best financial goal, but rather working to maximize after-tax returns will lead to improved financial outcomes. No one wants to pay more than required, but you also do not want the proverbial “tax tail to wag the dog.”

Regardless, don’t let them back down from the tough return environment and possible tax headwind.  And you don’t want to have a Breakdown and be Free Fallin’ while Running Down a Dream . . . . .

[i] Stocks:  Russell 3000 Index / Bonds: Bloomberg U.S. Aggregate Bond Index.

[ii] Advisor Perspectives:  https://www.advisorperspectives.com/commentaries/2021/10/15/capital-gains-distributions-the-trend-is-not-your-friend

[iii] https://www.ft.com/content/6a95ede1-5268-41c3-8ed5-5fc839bbf45f