Understanding Mutual Fund Capital Gains
Capital gains are a good thing. Unexpected tax bills are
not. But the reality is that capital gains taxes are part of the normal
(albeit unwelcome) 'price of admission' for investing. Specifically, it's the
price of successful investing. Only those who successfully realize capital
gains pay taxes on their success. In other words, it's a good problem to have.
How do capital gains work?
There are two kinds of capital gains with mutual fund
investing. First, an investor incurs a capital gain from selling shares at a
higher price than the price you paid for those shares. Second, capital gains also
occur when a mutual fund portfolio
manager sells shares of a stock held in the portfolio at gain from the price
he/she bought them (called realized capital gains). When the latter happens,
the mutual fund must pay out those capital gains, at least once a year, in
order to satisfy federal tax requirements. This payout is called a “distribution,”
and it is paid to each shareholder on a pro-rata (equally portioned) basis.
Due to the fact that STCGs may be subject to a higher tax rate than LTCGs, Weitz Investment Management prefers LTCGs to STCGs.
Mutual fund capital gain “distributions” are broken down
into two categories: long-term capital gains (LTCG) which occur when a stock is
sold after being held in the portfolio for longer than one year; and short-term
capital gains (STCG) which occur when a stock is sold after a holding period of
one year or less. LTCGs are taxed at a rate of either 0%, 15% or 20%. STCGs are
taxed as ordinary income, as are mutual fund distributions of dividends and
interest, and this ordinary income tax rate is higher than an investor's
long-term capital gains tax rate. Shareholders can choose to receive
distributions in cash or reinvest them into their account. Even when
distributions are reinvested, shareholders pay taxes on the amounts they
receive (unless their assets are held in a tax-advantaged account, such as a traditional
IRA or a Roth IRA).
Bond mutual funds also pay distributions. If an investor
holds shares of a taxable fixed income mutual fund, then the interest earned from
the bonds held inside the fund are generally paid out to shareholders, and
these distributions are taxed as ordinary income. Occasionally a fixed income
fund will also distribute a small LTCG or STCG.
Why do distributions cause fund prices to go down?
The frequency of distributions varies from fund to fund. Most equity mutual funds pay distributions once or twice a year. Fixed income and money market funds often pay on a monthly or quarterly basis.
When a fund's realized gain outweighs losses, they accumulate
inside the fund until distribution and contribute to the increase in the fund's
share price — also known as the net asset value (NAV). When this gain is paid
out in the form of a distribution, the fund's NAV decreases by the same amount
of the distribution (ignoring any fluctuation in NAV attributable to market
To explain this further, there are a few key terms to know.
- Record date: All shareholders of record at close of business on this day are eligible to receive the distribution.
- Ex-dividend date (ex-date): The date on which the per-share amount is deducted from the fund's NAV per share.
- Pay date: The date a fund pays the distribution to shareholders. This is also the reinvestment date for shareholders that choose to reinvest their distribution into the fund. The ex-date and the pay-date are both generally the business day after the record date.
Weitz portfolio managers are always mindful about the funds’ capital gains and the potential tax implications on shareholders. And while we are “tax aware,” in the words of CIO Wally Weitz, we’re not going to let the tax tail wag the investment dog. The investment objective of each of our funds supersedes any tax-related decisions.
Although we will occasionally sell a security that we no longer want to own with the knowledge that the sale will create a capital loss, thereby offsetting realized capital gains and reducing the tax burden on our shareholders, the purchase and sale of securities in a fund is first and foremost based on the fund’s investment objective.
For example, assume that today is the record date, and a
fund has a NAV of $20. The fund then declares a distribution of $2 per share
with an ex-date and pay date of tomorrow. Shareholders who own the fund today
will be entitled to receive the distribution, but anyone buying on, or after,
the ex-date will not.
Additionally, suppose you held 1,500 shares of the mutual
fund on the record date with a market value of $30,000 (1,500 x $20 per share).
You would receive $3,000 ($2 per share x 1,500 shares) in distributions on the
pay date. Your 1,500 shares would now be worth $27,000 (1,500 x $18 per share).
If you reinvested your distribution, your $3,000 would purchase an additional
166.667 ($3,000/$18 per share) shares on the pay date. Your new share balance
would be 1,666.667 (1,500 shares + 166.667 shares), still with a market value
of $30,000. The shareholder purchasing shares of the fund on the ex-date will
buy shares at $18 (again, ignoring fluctuations in NAV due to market activity).
When capital gains or income distributions are reinvested
into a mutual fund shareholder's account, the payout increases the cost basis
on that account. This is because the distribution is part of the shareholder's
tax information for the year it is paid.
Why do capital gains occur even when markets are down?
Capital gains are not tied to current market or fund-level
performance, they are determined by the sale of securities within a fund. Even
when markets are down, the sale of a security can still generate a gain, for
example if the gain had appreciated over many years.
How do mutual fund distributions differ from other types
All mutual funds, including index
funds, are required to pay out any realized gains to shareholders on a pro-rata
basis at least once a year. Typically, actively managed equity mutual funds
do so annually in the form of short-term and long-term capital gains. The total
capital gain payout will vary from year to year, and there may be years when a
mutual fund does not pay out any distribution. Index funds typically pay
dividends quarterly (which are taxable as ordinary income).
Investors who buy individual stocks pay the capital gains
taxes the year(s) they sell shares. If the stock is a dividend payer, then the
investor will generally receive those dividends in cash on a quarterly, biannual,
or annual basis and pay income tax on the total amount received each year.
Paying taxes is part of any successful investing process,
and mutual funds have the added benefit of providing shareholders with a
diversified portfolio managed by an investment professional.
The opinions expressed are those of Weitz Investment Management and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through the publication date, they are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor's specific objectives, financial needs, risk tolerance and time horizon.
All investments are subject to market risk, including the possible loss of principal. Holdings are subject to change and may not be representative of the Fund's current or future investments.
Investors should consider carefully the investment objectives, risks, and charges and expenses of a fund before investing. This and other important information is contained in the prospectus and summary prospectus, which may be obtained at weitzinvestments.com or from a financial advisor. Please read the prospectus carefully before investing.
Weitz Securities, Inc. is the distributor of the Weitz Funds.