When you own shares in a mutual fund you may get dividends from the fund company that were from the dividends earned by the individual stocks held by the fund. In additional you may get a “distribution” of short term and long term capital gains. These are usually issued in November or December.
Investors don’t like getting distributions from a mutual fund because this means taxes have to be paid. Investors emotionally feel that they should only have to pay tax when they take the initiative to sell an investment. However a mutual fund is a collective investment and when the fund manager sells assets then that may trigger a capital gain which must be paid by the individual shareholders because a mutual fund is a “pass-through” entity where taxable events in the fund are passed through to the individual shareholders.
Methods to avoid capital gains distributions:
- Hold mutual funds (that you suspect will give a distribution) in a traditional IRA. However that causes a worse tax problem: traditional IRA’s wash out the tax treatment of dividends and long term capital gains and convert them to ordinary income. So in most cases it would be very wrong to do this. Of course a Roth IRA is tax free, so that would be different.
- By mutual funds after the annual distribution has occurred. The problem is that investing (in theory) should be for the long run, so buying a fund in December and selling in October just to avoid distributions is wrong and impractical and would trigger short term gains tax (if it was profitable) on your sale of the mutual fund.
- Buy ETF’s to avoid capital gains distributions. They obtain shares of stocks through “creation units” which have a different tax consequence when these units are redeemed by an “authorized market maker” from a mutual fund. Unfortunately the goal of pursuing tax savings is trumped by the goal of getting good investments. I don’t recommend passive ETF’s because I believe in actively managed mutual funds. If an investor is trying too hard to chase after tax benefits an investor may not be able to make the right investment decisions.
- Recognize that distributions often occur for a reason: They may occur at the top of a bubble or just after the top when investors withdraw funds from a mutual fund the manager needs to sell assets to pay the investors who are redeeming mutual fund shares. These sales then trigger a distribution which is assessed on the remaining shareholders. So the best defense against distributions would be to avoid funds that are part of a bubble top because the fund’s assets will go down in value and will be sold to meet redemption requests. Thus you get two benefits by avoiding bubbles. Now the question is how do you spot and avoid bubbles? This is the real question that is far more important than avoiding distributions.
To avoid bubbles one should avoid over-priced investments and be a contrarian and avoid investing in what the masses believe in. Avoiding over-priced investments means watching the P.E. ratio and buying when it is at a discount below fair value and then selling assets when the P.E. is too high. This is one of many indicators. In some cases a low P.E. ratio is a “Value trap” where a P.E. ratio is low because a company is going to fail soon. So besides buying at the right price the assets purchased must be quality assets. “Quality” means stable, healthy earnings which is something the dotcom bubble stocks did not have. It also means low debts, a good corporate moat, good corporate governance (not opaque or manipulative behavior).
I am concerned that the commodities boom was a panic caused by speculators and by China worrying too much about dollar devaluation. I expect China’s economy to cool off and commodity speculation to collapse as it did in 2008. This will provoke investors in developed countries to become bearish about developed country stocks and then they will go down.
The Emerging Market economies are more fiscally sound than the U.S., so they may be a place to invest for the purpose of reducing the risk of dollar devaluation, or the risk of developed country government insolvency. Important: Get more information in my free Special Report about emerging market currency investing.