How to avoid active fund ‘tax bombs’
One risk that is not always top-of-mind when investing in active funds is what can happen when a fund faces large investor outflows.
Consider the case of Harbor International Fund, which has announced plans to make a capital gains distribution of about $9 billion, or 38% of its net asset value, this year.
About half the sale of its appreciated assets is because of departing investors redeeming their shares after a change in the fund manager, Harbor says on its website.
The distribution may create a huge surprise tax bill for anyone invested in the fund with taxable dollars. Because capital gains distributions are made on a pro-rata basis to all holders of fund shares, regardless of when they entered the fund, investors end up paying taxes on gains from which they did not benefit.
"You could have purchased that fund the day before, and you are still going to receive the cap gains distribution, and you could have a massive loss. At some point the need to sell those shares creates a tax bomb," says Christopher Van Slyke, a CFP and the founder and a partner with WorthPointe in Jackson Hole, Wyoming.
One big takeaway is don't invest taxable dollars in active funds, or eschew them entirely, he and other say.
“That's one of the inherent problems in active management, which is why we don't engage in it,” Van Slyke says.
His firm uses a passive investing approach, which, while not eliminating the tax bomb risk, reduces it, he says.
Another strategy is to avoid active funds with large unrealized gains, says Jeffrey Ptak, Morningstar's global director of manager research in Chicago.
And beware the risk that manager departures could prompt other investors to leave, forcing a fund to sell its appreciated assets to pay off departing shareholders, he says.
In the case of Harbor, the fund's board recently replaced its longtime manager, Northern Cross, with Marathon Asset Management, “which apparently intends to sell substantially all of the fund’s appreciated stock holdings in favor of different names they prefer,” Ptak says.
“Thus, what was already shaping up to be a trying year for the fund’s taxable investors became a bloodbath,” he says.
For advisors who use actively managed funds, such as Marge Schiller of M.K. Schiller Consulting in Sarasota, Florida, the chief way to avoid such a bloodbath is keep the funds in tax-deferred accounts.
“If I'm starting with a new client, I would prefer to put the index fund in the taxable account and the actively managed funds in the retirement account,” she says.
Ptak, Schiller and Van Slyke offer the following checklist to avoid active fund tax bombs:
1. Invest tax-deferred assets in actively managed funds.
2. Avoid funds that are sitting on large unrealized gains.
3. Consider that, as baby boomers age, more established fund managers are nearing retirement. When they leave their jobs or retire, investors often leave, too, forcing the fund to sell holdings to pay off the departing investors. “There are a lot of wonderful managers that are now retirement age,” Schiller says. “So you begin to see, in some of the great mutual funds of the last decade, that there are either partial or total management changes, which is a red flag.”
4. Don't invest in actively managed funds in the fall when fund managers are most likely to sell realized gains before the end of the year. “The big no-no that has been widely discussed over the decades is be careful buying an actively managed account in the autumn of the year because generally sometime in the fourth quarter, most actively managed mutual funds clear their cap gains and pay them, so that is when you have some risk,” Schiller says.
This story is part of a 30-30 series on tax-advantaged investing.