$20 Billion To Uncle Sam

October 30, 2006

U.S. mutual fund investors could pay $20 billion in capital gains taxes this year, the third-largest year on record; will enhanced index funds take a hit?

The tax man cometh … and he's hungry.

That's the message from a handful of tax analysts popping up around the country, who warn that 2006 could be one of the worst years for capital gains distributions on record.  Investors got a bit of a respite from the tax man from 2002-2005, as fund companies used the losses harvested in the wake of the Internet bubble to limit distributions.  But with the bull market stretching on into its third year, those tax credits are used up, and now Uncle Sam wants his due.

According to a recent article in Investment News, mutual fund investors could cough up over $20 billion in taxes this year, as fund companies pay out over $200 billion in gains.  That nearly 4X the level of gains paid out in 2004 ($55 billion), and 14X the level paid in 2003 ($14 billion).

In fact, 2006 could rank as the third-highest year in history for fund payouts, ranking behind only the $326 billion payout in 2000 and the $238 billion payout in 1999.

The fallout from all this should be significant, reminding investors - once again - of the importance of focusing on after-tax returns (and that means focusing on low-turnover funds, like … well, like index funds, of course). As John Bogle has pointed out time and again, taxes take a huge chunk out of the returns of most investors. Between 1983-2003, the average actively managed equity fund forfeited 2.2 percent of its annual returns to taxes, while the average S&P 500 Index Fund lost just 0.9 percent in tax payouts.

Exchange-traded funds (ETFs) have had an excellent run on the tax front, with many paying out zero capital gains in recent years (PowerShares, Barclays, etc.).  Rising market prices may make this more difficult in the future, but the inherent tax efficiency of the ETF creation and redemption mechanism should let the more actively traded funds keep payouts low.

A few questions, however, bear watching on both the ETF and the index front.

For one, will enhanced and fundamentally weighted index funds pay out larger distributions than their traditional market-cap-weighted cousins? Most of these funds are rebalanced on a quarterly or bi-annual basis, as a way to bring component weights back in line with the fundamental targets. Almost by definition, this involves selling the shares of companies whose stocks have performed well, and buying shares of companies whose stocks have fallen.  That's a perfect recipe for capital gains, and it will be interesting to see if these new non-traditional index funds suffer on an after-tax performance basis.  The new funds will be helped by the fact that they are, for the most part, ETFs; the tax disadvantages of the regular rebalancing will flow more directly to traditional mutual fund holders.


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