Unrealized Capital Gains

There is a little known problem with many mutual funds today…unrealized capital gains.

Suppose you buy Vanguard’s S&P 500 Mutual Fund ($VFINX) and hold it over the next 10 years. You never sell it so you never pay any taxes…right? Actually, you might end up paying a lot of taxes! The reason is that the investment tax you owe depends both on your own buying and selling and on that of your funds.
Funds have to pay capital gains taxes just like individuals and are required to pass these expenses on to investors at least once a year in what is called a “taxable distribution”. These distributions will occur when a fund sells securities that have unrealized capital gains, just like for individuals. When a fund issues a taxable distribution, all holders of a fund are subject to the taxable distribution regardless of when they bought the fund. So if you buy a fund whose value is comprized of 37% unrealized capital gains and the fund is forced to liquidate the next day, you  lose 5.55%:
Loss = 37% * (1 – long term tax rate of 15%) = 5.55%
Unrealized capital gains of 37% sounds like alot but that is the actual amount for VFINX.
So how big a deal is this?
The best example we could find (and by that we mean the worst case) is that of Columbia Acorn Z (ACTWX). ACTWX, a mutual fund, was essentially flat in the year 2015 losing only 0.44%, but passed on a $7.14 capital gain or nearly 30% of the share price! This happened because the fund sold about 55 percent of its holdings. That means someone invested in ACTWX during the year 2015, that did not sell their shares, would have to pay taxes on 30% of their investment even though the share price was essentially flat…because of a realized capital gains tax distribution (a distribution to the government…not the investor).
This applies to mutual funds like VFINX. Vanguard has been growing rapidly (left)! When mutual funds are growing they rarely need to sell securities. Combine this with a doubling in the price of VFINX over the past five years (right) and you have the perfect recipe for large unrealized capital gains.
Now some of you may still think that this isn’t a big deal because of the trend toward indexing. Indexing reduces the likelihood of taxable realized gains because of reduced portfolio turnover. Most index funds are weighted by market capitalization, so when the price rises the target weight rises along with it leaving the portfolio manager with little to do but twiddle their thumbs. The rise in index investing is partially responsible for the rise of Vanguard.
So long as this trend continues it should mitigate the need for index funds like VFINX to sell securities, but there is always the risk that investors will chose one fund over another. One cybersecurity attack or Londen Whale type incident could hurt any company’s reputation, causing some customers to leave. Any idiosyncratic event that targets one particular fund could potentially lead a fund to liquidate, triggering a taxable event.
To be fair to mutual funds, managers take advantage of carrying capital losses from prior years, tax-loss harvesting, and other tax mitigation strategies to diminish the impact of annual capital gains taxes. In addition, index mutual funds are far more tax efficient than actively managed funds because of lower turnover. Still it seems like an unnecessary risk when there is an easy alternative that often has lower expense ratios.
ETFs over Mutual Funds
This risk can largely be avoided by using ETFs instead of mutual funds. Mutual funds must sell securities to accommodate net shareholder redemptions. This sale creates capital gains for the shareholders, even for shareholders who may have an unrealized loss on the investment. In contrast, ETFs accommodate outflows by redeeming “creation units,” which are baskets of assets that approximate the entirety of the ETF investment exposure. As a result, ETF investors are usually not exposed to capital gains on individual securities.
Another step is to stick with market capitalization weighted index funds. Index ETFs usually only sell holdings when the elements that comprize their underlying index change. So long as the turnover rate is this, this should translate into significantly fewer taxable gain incidents.
So how often does the S&P 500 turnover?
According to a study of turnover in the S&P 500, half the firms will be replaced within the next 10 years. That is about 5% a year. Importantly, the companies being replaced are more likely to be smaller companies because firms only get dropped from the S&P 500 if they lose value relative to other firms, go private, or are acquired. All three of these situations are more likely to occur with smaller firms that have had unrealized capital losses rather than gains. Therefore, the more important question is, “how much does turnover contribute to realized capital gains?”
Here is a quick estimate. Apple comprises 4% of the S&P 500 all by itself. On the other end we have companies like SCANA Corporation, #475, with a weight of just 0.028% and Envision Healthcare Corp., #500, with a weight of just 0.014%. Suppose the average weight of the bottom 5% of firms is 0.02%. That would bring their total weight to about 0.02% * 25 = 0.5%. Combine this with the 37% unrealized capital gain in VFINX and you get a 0.185% capital gains tax charge each year.
This calculation, however, assumes these companies contain an average amount of capital gains. This is certainly not the case. As mentioned, firms only drop out of the S&P 500 when they lose value or are bought out. Those that drop out from losing value are almost certainly not going to have material capital gains exposure. Shares of buyout targets are also typically under pressure. There are also other reasons why index fund managers need to sell shares such as changes in the free float factor. But it is safe to say that market capitalization weighted ETFs are not at risk of large tax charges from realizing capital gains.
What’s even better is that ETFs generally have lower expense ratios. VFINX has an expense ratio of 0.14% compared to just 0.04% for VOO (Vanguard’s S&P 500 ETF).
Stay Tuned! In our next post we will share our secret to beating markets via tax loss harvesting.

Feel free to share your own thoughts on unrealized capital gains. There is no better compliment you can give us than your thoughtful criticism. You can reach us at intuitecon@gmail.com, or follow us on Twitter @intuitecon


IntuitEcon Team

Disclaimer: We are long $VOO. This article is not, and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action. Our hope is that these observations will merely help you to more critically examine your own beliefs about finance and stimulate dialogue.

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