Anatomy Of A Mutual Fund Tax Land Mine

Why one mutual fund is headed for a monster tax problem.

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Reviewed by: Dave Nadig
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Edited by: Dave Nadig

Why one mutual fund is headed for a monster tax problem.

Yesterday the Wall St. Journal reported on a handful of mutual funds expected to have a particularly hard time with capital gains this year. The poster child for the unfairness of the mutual fund taxation system may end up being the Neuberger Berman Large Cap Disciplined Growth Fund. Here's the crucial passage from the article:

"One fund planning a whopping distribution is the $152.4 million Neuberger Berman Large Cap Disciplined Growth fund. Large investors bailed out of the fund this year, which has lagged behind the S&P 500 Index since 2010, forcing it to sell securities that had appreciated greatly over the years. As a result, the fund is expected to pay out more than 50 percent of its net asset value Dec. 16."

That's a claim worth teasing out, and I thought it would make a great example to explain what actually happens in a situation like this.

First, a little bit about this fund—it's a large-cap growth fund that sets its bogey as the Russell 1000 Growth Index. In the fiscal year ended Aug. 31, 2014, it returned anywhere from 12.18 percent to 19.41 percent, depending on which of the seven share classes you held. (Don't you love mutual funds?) Being charitable, even that 19.41 percent was far behind the index, which was up 26.29 percent. That underperformance persists for one, five and even 10 years and since inception.

In other words, it's just not a very good fund. And to make matters worse, the guy running it just retired, and a new guy, John Barker, took over the reins in August.

Jumping Ship

So what did people do in 2014? They took money out. And when they took their money out, they forced the fund to sell securities. Because the fund has generally had a positive run—by that I mean it's not losing money even though it didn't beat its benchmark—most of its positions are held at implied gains. By selling, the fund booked those gains.

How many people sold? Through the fiscal year ended Aug. 31, the fund had $251 million in redemptions, following $270 million in redemptions the year prior.

Here's the problem. First off, if Bob is somehow convinced this is a good fund, shouldn't someone tell him he's walking into a giant distribution before he buys? If he looks online, he won't find a press release telling him about the monster hit coming his way if he were to buy in right now.

You won't find a banner on the website. You'll have to hunt around for the Tax Documents page and then dig in. Once there, you have to scan through until you find this gem:

Investor Class Shares
2014 Year-End Income and Capital Gain Distributions - Estimates

FundTickerFund
Number
Income
Dividend1
Short-Term
Capital Gain2
Long-Term
Capital Gain3
Total
FocusNBSSX494$0.14 - $0.20$0.45 - $0.51$3.69 - $3.75$4.28 - $4.46
GenesisNBGNX493$0.06 - $0.12None$4.74 - $4.80$4.80 - $4.92
GuardianNGUAX484$0.12 - $0.18$0.06 - $0.12$2.55 - $2.61$2.73 - $2.91
International EquityNIQVX495$0.12 - $0.18NoneNone$0.12 - $0.18
Large Cap
Disciplined Growth
NBCIX1257$0.14 - $0.20$0.55 - $0.61$3.73 - $3.79$4.42 - $4.60

 

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Neuberger Berman conveniently (irony) doesn't tell you what the net asset value (NAV) is or express this in percentages. So, it's only when you start looking up the current NAVs for these funds ($8.62 for Large Cap Discipline) that you can start doing the math and realize that half your investment is going to immediately get handed right back to you with outrageously terrible tax treatment.

To put real numbers on it: if I put $10,000 into this fund today, at $8.72, I will, in two weeks, be handed back $5,336 of my investment and told that I immediately owe taxes on that as capital gains. If you do the splits right, you're writing a check for $1,511.32 cents.

Anatomy Of Outrage

To suggest this is unfair is an understatement of significant proportion.

It's important to point out that the folks who sold—all $250 million of them—don't magically get the benefit of this unfairness. They still have to pay capital gains based on the current NAV when they sold and based on their original cost basis. So what actually happens here isn't so much a shifting of burden from the seller to the holder as the Internal Revenue Service getting two runs at the taxpayer buffet.

What's really happened in some sense is that Bob is "prepaying" his future tax liability.

His cost basis for his investment is still $10,000, and that cost basis is not adjusted when the value of his investment plummets $5,336. So if he chose to immediately sell his shares, he would have an offsetting loss for the capital gain he just got handed.

So Bob can dodge the bullet here, but along the way, he's tied up his money in a rat race of irrelevant tax manipulation, suffered whatever market move may have happened, possibly paid a transaction fee or a sales load, and kicked in part of a 75 basis point management fee for the privilege.

What If It Were An ETF?

But consider how much cleaner this is if the fund had been an ETF all this time.

As investors wanted to get out, the manager would have simply handed baskets of low-basis stocks out to the authorized participants, wiping away huge swaths of unrealized capital gains in the process. This doesn't make Bob's life magically tax-free, but it does mean he's only going to pay taxes on his personal experience, when he actually chooses to sell.

We're still compiling estimates for ETFs for 2014, certainly, because of the volatile and generally positive markets, some ETFs will have some distributable gains. But I'll be shocked if I ever see a plain-vanilla U.S. equity ETF hand back 50 percent of its assets.


Contact Dave Nadig at [email protected].

 

Prior to becoming chief investment officer and director of research at ETF Trends, Dave Nadig was managing director of etf.com. Previously, he was director of ETFs at FactSet Research Systems. Before that, as managing director at BGI, Nadig helped design some of the first ETFs. As co-founder of Cerulli Associates, he conducted some of the earliest research on fee-only financial advisors and the rise of indexing.