I GOT AN ANGUISHED call from an investor last week. Let’s call her Emily. Emily’s accountant was finishing up her tax return and was surprised to see a $113,000 capital gain. The explanation turned out to be just as surprising.
The issue stemmed from a well-intentioned move by Vanguard Group. In late 2020, the firm announced it was broadening access to a set of lower-cost mutual fund share classes.
Mutual fund share classes are like fare classes on an airplane. Just as every passenger on a plane is going to the same destination, every investor in a mutual fund owns the same underlying investments. The difference, though, is that some share classes cost more than others, just as some seats on a plane cost more. But in the case of a fund, the best share class to own is the one with the lowest costs. Fund firms restrict access to lower-cost share classes by, say, requiring a larger initial investment.
What Vanguard did was to lower the minimum investment required to get into some lower-cost share classes. So far, this may not sound like a problem. You may recall, though, that investing in mutual funds always carries a risk: Being a shareholder in a fund is like being a passenger on an elevator. Everything should be just fine—as long as everyone behaves. By that, I mean that investors in a fund can impact each other if they choose to sell out of a fund in large numbers.
That’s exactly what happened. When Vanguard invited more investors into the lower-cost share classes, they predictably headed for the exits of the higher-cost shares. The result was a disaster for those left behind, including Emily.
Why was it a disaster? To understand what happened, think about it from the fund manager’s perspective. If an investor wants to redeem his or her investment, the fund manager must make cash available for that redemption. That happens every day in mutual funds and generally it isn’t a problem. Often, in fact, incoming cash from new shareholders can be used to redeem investors who are exiting. In addition, fund managers always maintain cash on the side for this purpose.
But what if there are more redemption requests than new investors on a given day? The fund manager must sell some of the fund’s holdings to cash out those who are exiting. This, too, often isn’t an issue. But if too many redemption requests come in at once, the fund manager may be forced to sell a large number of investments that are worth more than the price that the fund paid. This is where the unpleasantness begins.
By law, mutual funds must distribute substantially all of their net income each year. That income is distributed pro-rata to shareholders, and each is taxed on the amount they receive if they hold the fund in a regular taxable account. If a fund incurs extraordinary gains—as the Vanguard funds did—then shareholders like Emily will be stuck with the tax bill, and they have no say in the matter.
That would be bad enough—but there’s more. Mutual fund companies generally only make capital gains distributions once a year, near the end of the year. That’s when they have a good sense of each fund’s total income. For logistical reasons, they only make distributions to investors who are shareholders at the time when the distribution is issued. In other words, if a stampede of investors leaves a fund in June, they might trigger a pile of capital gains, but they won’t be responsible for the gains they triggered. Instead, it’s the hapless folks remaining in the fund in December who’ll have to pick up the tab.
That’s precisely what happened to many Vanguard investors last year. Emily and others are now stuck with the bill. The only potential silver lining: The situation was egregious enough to attract government attention. The state of Massachusetts was able to secure a $5.5 million settlement for shareholders. A pending class action lawsuit may provide broader relief.
As an investor, how can you avoid this sort of unpleasant surprise? Here are five recommendations.
First, avoid actively managed funds. Their managers usually trade more and that greater activity is likely to generate taxable gains. Worse yet, as I described earlier this year, actively managed funds are totally unpredictable. While index funds are not immune to generating gains, those gains tend to be much more muted because the portfolio manager doesn’t have the freedom to buy and sell as the mood moves him.
Second, stick with Vanguard. That might seem contradictory, given last year’s ugly incident. But I see that as more the exception than the rule. The reality is, Vanguard is uniquely positioned to minimize gains for investors. For example, it has a patent on one technique that’s highly complex but enormously effective. Vanguard also leads the industry in lowering fees.
Third, avoid funds that own a mix of asset classes, such as stock-bond “balanced” funds or target-date retirement funds. Their selling point is that they offer ready-made portfolios, with the managers making regular adjustments to keep them in line with their stated strategies. It’s these adjustments, though, that present a problem. They entail more frequent trading, so it’s hard to know what kind of tax bill these funds will generate.
Fourth, avoid niche funds, such as a fund that owns only technology stocks or health care stocks. Even if they’re index funds, a narrowly focused fund is going to be more susceptible to unexpected trading gains. When you stick with a broader fund, like an S&P 500 or total stock market index fund, it’s like being on a big ship. You’re much less likely to be impacted by a few waves.
Finally, opt for exchange-traded funds (ETFs) over traditional mutual funds. Their structure makes them inherently more tax-efficient. As I noted earlier, Vanguard has done an impressive job limiting the capital gains generated by its mutual funds. But ETFs go a step further in insulating investors from potential gains.
That said, if you feel compelled to own a less tax-efficient fund, try to buy it in a retirement account. The fund will still generate distributions, but they won’t lead to an immediate tax bill.
If you do choose to buy something other than a simple index fund in a taxable account, there’s one thing you can do to lessen the potential impact: Consult the mutual fund company’s website before you make your purchase. As the end of the year approaches, each fund company publishes a schedule of upcoming distributions. At the very least, wait until the day after the distribution to make your purchase. That will allow you to sidestep one year’s tax bill.
What if you already own a fund that’s tax inefficient, and it’s in a taxable account? If you have an unrealized loss, of course you could sell it. But if you’re hemmed in by a sizable gain, there is one thing you can do: Be sure your account isn’t set up to automatically reinvest income and capital gains distributions. You’ll still owe tax when you receive those distributions, but at least you can take that cash and reinvest it elsewhere.