The market continues its roller coaster ride for 2022. Typical stock mutual funds are down 20%. This decline is problematic enough, but adding insult to injury, taxes are about to make it worse for fund owners.
Long-time readers will remember my numerous posts about the tax differences between various mutual fund structures. Since deferral or elimination of taxes can add 60% to long-term returns all else being equal, it’s worth paying attention.
Open-end funds have a unique and unfavorable tax structure that is about to become very evident for shareholders. These funds have commingled share accounting which mixes the taxable activity for all shareholders. Investors who enter and exit the fund cause taxable activity for all shareholders. Open ends can be identified as any fund with five letters in its symbol, like any Fidelity mutual fund, since they only operate open-end funds. Closed-end fund structures like exchange-traded funds (ETFs) are generally exempt from this problem and typically have three letters in their symbol.
This year, funds have experienced very high transaction activity while at the same time producing net losses in value. This dynamic will prove very painful for investors. It’s particularly agonizing to write tax checks for investments that have lost money. Transaction activity happens for several reasons; the fund could have a change in management, causing realignments of investments, or it could be caused by big outflows of selling shareholders.
Morningstar tracks these accumulated taxable gains, which are often distributed and reinvested in December of each year. This year will be a doozy. There are dozens of funds on the Morningstar list that will likely make taxable distributions this year in excess of 75% of the fund’s value. Investors might be able to fix this by selling their fund shares and repurchasing them after the distribution. Of course, everyone’s situation is different, so don’t take this as advice for you. Seek tax counsel.
Segment addresses these issues by only owning ETFs for our clients or, better yet, the individual securities comprising our desired market exposure. We too have had larger taxable activity for this year, but it’s more like 8%, and for the past three years has approached zero. That 8% might feel like a spike, but the broader perspective indicates just how tax efficient we are in comparison.
If you wish to read more about how these funds are structured and track how ETFs manifest better tax outcomes, you should visit our blog page on the Segment website. I have written articles for Forbes and have numerous blog posts about the beneficial tax treatment of ETFs.
Here are the links to a few of these:
Gil’s Musings: Why Are ETFs Better Than Mutual Funds?
Forbes Council: The Implications of Biden’s Proposed Tax Changes
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