It’s that time of year when mutual funds are required to distribute to shareholders any profits realized from trading, net of any losses, in the form of capital gain distributions.

What Are Capital Gain Distributions?

You’re probably already aware: If you sell a holding from your taxable account for more than you paid for it, you must report the capital gains on your tax return.

In similar fashion, mutual funds must distribute to shareholders any net profits from the fund’s underlying trading. This is true even if you personally made no trades in that fund during the year.

How Do Distributions Work?

When a fund distribution is paid, its share price declines by the amount of the distribution.

Consider that you’re invested in a fund priced at $20 per share, and it distributes a 5% long-term capital gain of $1. After the distribution, your shares would be worth $19 per share, and you’d receive $1 per share in cash (or in new fund shares if you’ve elected to have dividends reinvested).

The combined value of the $19 share plus the $1 in cash equals the pre-distribution price of $20. However, if you own the fund outside of a retirement account (or similarly tax-sheltered account), you must report the $1 of cash as a taxable distribution.

Keep in mind, the cash distribution is not always received into accounts until the day after the share price change. As a result, it can temporarily appear as if the entire account has declined by more than it has. Not to worry; the cash distribution will appear shortly.

Why Are There Distributions in a Down Year?

While we don’t buy and sell frequently, mutual fund managers may trade every day. Traditional active managers tend to trade the most, and some Wall Street giants are distributing more than 20% of their funds’ net asset values this year, despite delivering double digit losses to investors. That’s salt in the wounds.

With index and asset class stock funds, however, much of this trading is to simply invest a funds’ significant cash flows in alignment with its target objective.

In pursuing that objective, a manager may sell a specific winning stock at a gain even though the entire fund has declined in value. If enough such gains are realized throughout the year, a fund may distribute a capital gain.

Take DFA’s US Vector Equity Fund, for example, which invests broadly in U.S. stocks but favors small cap and lower-priced value shares. The fund is making a roughly 3.5% capital gain distribution this year, even though performance is negative. The fund was down -4.6% for the year, through November.

Despite the period’s negative return, the fund did outperform the comparable U.S. stock market by more than 10%, in large part due to its holdings of value stocks. Prudently paring back its winning growth stocks to ensure a full measure of value stock exposure is, in part, what enabled the fund to capture the outsized returns value stocks have delivered this year. Even after factoring taxes on that distribution, the fund still outperformed.

What Can We Do About Distributions?

Taxable year-end capital gain distributions aren’t the kind of holiday surprise anyone prefers to receive, particularly in a down year. That’s why we take year-round steps to minimize their impact on portfolio performance.

Shunning Actively Managed Funds

First, we favor index and asset class funds from firms like Vanguard and Dimensional Fund Advisors. In addition to their lower costs, these funds tend to be more tax-friendly than actively managed funds.

Asset Location

We prefer to hold funds that are less likely to generate distributions in clients’ taxable accounts. We then reserve tax-sheltered accounts for those funds that we expect to pay out higher levels of income or gains.

Tax-Loss Harvesting

We also strategically use tax-loss harvesting—trimming positions temporarily trading at a loss and immediately replacing them with a similar investment to remain fully invested—to offset realized gains and distributions.

Patient Trading Around Distribution Dates

We may hold off on investing new cash in taxable accounts if we know a fund plans to make a sizeable year-end distribution. Mindful of “buying a tax bill we didn’t earn,” waiting to invest until after a distribution has been made can often outweigh the benefits of investing new cash immediately.

To Summarize

While we generally don’t like large capital gain distributions, it’s not a fund’s absolute level of distributions that matters most, but a portfolio’s after-tax return.

Rest assured, Vista continues to work diligently to minimize the frictional costs of investing—including taxes on year-end capital gain distributions—as we seek to maximize the net return in your pockets.