In a period of high market volatility like now, many mutual funds can be capital gains time bombs for investors including those buy-and-hold types who do just as their advisors recommend and sit tight while everyone else is fleeing the market.

As a result, according to Bill White, president and chief operating officer of ReFlow Services, a San Francisco-based redemption-in-kind liquidity service serving the mutual fund industry, it is critical that financial advisors carefully examine how tax efficient the mutual funds that they recommend to clients really are.

As White put it in an interview with Financial Planning, “When you have a volatile market, you have volatility of the underlying holdings, of course, but you also have volatile shareholders in the fund.”

He explained that if shareholders pile out of mutual funds, it can force funds that have an inadequate cash “cushion” to handle a wave of redemptions to have to sell positions to raise funds to pay out to those departing investors. If they sell holdings that have gained in value, that creates capital gains which are then, at year’s end, parceled out to all investors in the fund -- even those who didn’t do anything but just leave their money invested all year long.

“What this means,” said White, “is that financial advisors cannot just look at one year’s fund performance. They have to check how tax efficient a fund was over a number of years and periods of high inflows and outflows.”  Such information is available, he said, because capital gains pass-throughs have to be reported.  The information on fund tax efficiency is also reported by outfits like Morningstar.

“Advisors need to be proactive to make sure their clients are not hit with unexpected capital gains taxes by their mutual funds,” he warned.

White said that ReFlow is a company that offers mutual funds one way of avoiding having to realize capital gains during a period of heavy fund outflows. He said his firm does this by buying shares from a fund if that fund faces heavy outflows that exceed its cash buffer, thus providing it with the cash the fund needs to cover the redemptions and saving it from having to sell any stock positions. 

Then, as funds flow back into the mutual fund, ReFlow will redeem its holdings by a corresponding amount.  It charges a fee -- typically around 15 basis points -- for this service, with the fee set in a daily auction.