Year End Fund Trading

December 1, 2006

The end of the year is a tough time for fund investors. December is when most fund companies make large taxable distributions. December is particularly punishing after a few good years of stock market returns, which can lead to gains on the fund’s books that have to be distributed.

These distributions are not good things. Unfortunately, year-end distributions are hard to avoid completely. Selling a fund right before a distribution could incur short-term redemption fees (at fund and broker) and taxable gains. 

The short story is to avoid buying funds (usually just stock funds) at the end of the year in taxable accounts (IRAs and 401ks are ok) without checking on any pending distributions. Pay particular attention to high payouts that are mostly short-term capital gains or income distributions, which are taxable at ordinary income tax rates.

But what about trading out of one fund and into another? In this case, it is possible that buying a year end distribution is not a bad idea because you may be avoiding one as well. Since we tend to sell funds that run up, and buy more out of favor funds, it’s possible you’ll be avoiding a payout. You may even go to a money market account for a few days between the two trades and avoid year end distributions entirely. In some cases, the end of the year could be the best time to make changes to your portfolio.

Since  we have made trades in five of our Powerfund Portfolios effective December 1st, such analysis is relevant.  When funds payout taxable distributions, the fund price falls the amount of the distribution; it’s just a question of converting future gains to current gains, and at what tax rate. (Since tax deferred accounts push off all gains, when and how a fund pays you, so long as you reinvest, is not important).

We are buying the following new funds as part of the recent trade

  • Janus Research (JARFX) in the Safety, Conservative, and Aggressive Growth portfolios
  • PRIMECAP Odyssey Growth (POGRX) in Growth (and increased in Daredevil)
  • SPDR Biotech (XBI) in Aggressive Growth and Daredevil
  • ProFunds Short Real Estate (SRPIX) in Daredevil

Of the bunch, only Janus Research (JARFX) is worth worrying about. We’ll address that fund last.

PRIMECAP Odyssey Growth (POGRX) has been growing assets. An expanding shareholder base tends to water down any year-end distributions. If a fund manager turns $10 million into $20 million through hot stock picks and realizes the gains, then $200 million in new investor money is invested into the fund, the $10 million gain gets spread to $220 million in shareholders – a small distribution. 

More importantly, PRIMECAP’s strategy is low turnover. This means the fund manager doesn't trade the stocks in his fund very often.  The fund  has to realize a gain in order to be forced by the IRS to pay it out each year. This is why index funds tend to be tax efficient. It also means year end distributions tend to be longer term capital gains, and investors don’t need to avoid these as astutely with long-term capital gains’ lower rates. 

PRIMECAP Odyssey Stock (POSKX), which is in some of our portfolios, is paying out a meager 1.59% distribution, much of it long term capital gains. Our newly added (to some portfolios) and increased stake in PRIMECAP Odyssey Growth (POGRX) is paying out a more noteworthy 4.59% distribution. Unfortunately, the fund company does not yet know when this will happen– though the third week of December is a likely time. About a third of that distribution is going to be long term capital gains. The fund charges a 2% redemption fee for shares sold within 60 days. You may want to delay buying, but we expect the final distribution to be a bit lower per shareholder given recent inflows.

SPDR Biotech (XBI) is an ETF. With ETFs (exchange traded funds) big year-end distributions of income and short-term capital gains are not a big worry like with open end funds. As for alternative biotech fund choices like Fidelity Select Biotech (FBIOX), don’t expect big dividends because these funds have lost investors significant amounts of money in the last few years. Those funds hit hard in the last bear market are likely sitting on tax loss carryforwards in the millions of dollars and can use those to wipe out other gains.

ProFunds Short Real Estate (SRPIX). Interestingly, ProFunds does not provide estimated distributions or dates – they fear investors leaving pre-dividend (sort of like we advise people to do in some cases….) and making a bad thing worse for other shareholders – those left holding the bag. Don’t worry. This fund lost too much money for investors to have to worry much about year end distributions. Moreover, those who go in and out of ProFunds and Rydex funds tend to buy and sell at inopportune times, leaving a wake of tax loss carryforwards on the funds' books – in both long and short funds.

Janus Research (JARFX) has a moderately high turnover and has had a good performance run. Worse from a tax distribution point of view, the Janus name is still a bit tarnished so the fund hasn’t brought in much money to water down the gains realized by the manager. Unlike other Janus funds, Research is new and didn’t lose any money in the bear market of 2000-2002. Most other Janus funds have minimal year end distributions in 2006 because of bountiful loss carryforwards - even though many of their funds did well this year.

If you own Janus Research (which will soon be renamed Janus Global Research) on December 14th, 2006 you will receive the year end distribution. Buy it on December 15th, and you’ll avoid the payout. 

The fund is distributing (allegedly - these numbers can go up or down) $0.88 per share, or about 6.44% of NAV – which is just enough of a distribution for it to matter. Of that, $0.26 will be long-term capital gains, leaving an ordinary income distribution (the high tax kind) of just under 5% of NAV. While not a crushing hit, 5% is worth missing if you can – especially with new money.

But should you stay in the fund you’re selling? Or go to a cash (money market) fund? Nobody knows what the market will do in a few days, but you’ll probably kick yourself if the fund takes off and you miss the action (or be ecstatic if the market crashes right when you’re playing tax avoidance). 

The new Janus fund doesn’t currently have a short-term redemption fee. Assuming you don’t have to worry about short-term fees imposed by a broker (say you purchased through the fund) you can sell then re-buy after the distribution (if you already own it). After 12/31/06, though, such shenanigans won’t work; the fund is imposing a 2% redemption fee for sales made within three months.

Taking things portfolio by portfolio - in the case of the Safety portfolio, investors are not selling any funds with big year end payouts, so sticking around in them won’t hurt. In the Conservative portfolio investors are selling an ETF – one that’s up pretty big this year and one we’ve only owned a short time. This means it is likely that short-term capital gains will be due on the sale itself not on any distributions paid by the fund. It could be worth sticking in the fund until January 1st or going to cash after selling before buying Janus.

In Aggressive Growth (and Growth, but we’re not buying Janus Research there) the real dividend action is in what investors are selling. Artisan International Small Cap (ARTJX) is paying out roughly an 18% distribution - $4.50 per share. Yikes. You’ll get the distribution if you own the fund on 12/19/06 – but we’re selling our entire stake by then.

Don’t blame the fund - it’s up around 200% since we bought it. The fund company expects about 70% of the payout to be long-term capital gains – which investors  will owe if they sell the fund anyway because they're probably up on the position. If you bought the fund recently (in the last 12 months) you may want to get the distribution before you sell. This would turn a short-term capital gains (your sale) into a long-term capital gains (the distribution)!

The bottom line is that there are no big tax bombs related to these trades. Other variables are likely more important, like your own gains and losses on these positions and others, and your broker’s short-term fund trading commissions (and/or the fund’s short term redemption fees). If you have tax loss carryforwards, year-end fund distributions are not as big a deal.