Each year I find tens of funds that have distributions over 20% of their NAV. (See my “Doghouse” list in the Articles section of this site.) These funds will create tax issues for shareholders that own these in taxable accounts.
As it turns out, there are some indicators that your fund might have bigger than average distributions in the near future:
- High Turnover – Fund managers that are buying and selling then buying and selling then buying and selling again are going to (hopefully) realize gains along the way. These gains will be passed along to shareholders each year. Worst of all, if the fund is grinding out short-term gains, these are taxed as ordinary income and will be taxed at your highest tax rate.
- High PCGE – Potential Capital Gains Exposure (PCGE) is a number that indicates the current embedded gains in a fund. For example, a PCGE of 50% means half of the fund’s value is considered gain if sold. Low or negative (indicating embedded loss) PCGE funds aren’t likely going to make big distributions. PCGE numbers can be found through some of the mutual fund information services.
- Shrinking Fund – A fund that is losing a good portion of their assets has two problems that they are not able to control: (a) The fund has to sell securities to raise the cash needed to make fund payouts; these sales can result in capital gains that will increase the amount they will have to pay out. (b) Funds only distribute to the shareholders still in the fund on its record date. For example, a fund that loses half of its assets will double the distribution percentage they will make to the remaining shareholders.
- New Management – When there is management change at a fund, there can be some major holdings changes in that first transition year. Some takeover managers have styles that fit well with the current holdings and require few trades, some “morph” the fund to meet their styles over time, and some trade virtually the entire portfolio in a very short period making it their own. It’s good to find out which of these is the case when there is a management change in your fund.
For the most part, funds on the Doghouse list are shrinking funds and funds with management changes (sometimes both). Either of these might be a good reason to reevaluate the fund even if taxable distributions are not an issue.