How To Avoid Distributions and Build Tax Efficient Portfolios
At the end of every calendar year, many mutual fund managers distribute capital gains to shareholders, delivering tax implications that are equally painful for advisors and their clients.
As an advisor, you’re tasked not only with helping your clients manage their investments, but also managing the tax implications of gains and losses from those investments. So how can you strategically position your portfolio to combat distributions and be more tax efficient?
YCharts, a popular tool among financial advisors, provides data and tools to help advisors avoid distributions and provide even greater value to their clients.
Advisors use YCharts to evaluate mutual funds in their portfolios, identify those likely to have large capital gains distributions, and make data-driven recommendations to their clients.
(Disclosure: you should always check a fund manager’s website for tax information pertinent to their funds and its investors.)
To learn more, read End The Year with More AUM, Less Distributions.
Leveraging data to find tax inefficiencies
Until they are actually distributed, it’s difficult to know the exact value of any long or short-term capital gains that will be passed down to a fund’s investors. That said, data and technology can help you find and avoid funds that are likely to have the largest distributions.
We’ll use the metrics below to identify those funds:
Potential Capital Gain — an estimated percentage of a fund’s assets that may be distributed as future capital gains; this metric is an estimate and is provided by Morningstar ®
Distribution Yield — the percentage of the current share price that an investor received as distributions, including both dividends and capital gains, over the past 12 months
Tax Cost Ratio — the percentage point reduction to a fund’s annualized return due to taxes that investors must pay on distributions in the calendar year (including stock and bond dividends and capital gains distributions); also known as tax efficiency
Turnover Ratio — the percentage of a mutual fund’s holdings that have been replaced over the past twelve month period
Then, we’ll use a YCharts Scoring Model to combine the four metrics above and rank funds by how likely they are to dole out large distributions.
Evaluating mutual funds in your portfolio for tax efficiency
The objective of this exercise is to identify mutual funds in your portfolio(s) that may pay out large distributions, then replace those funds with alternatives that are hopefully more tax efficient.
Starting in Comp Tables, bring in all the mutual funds in your portfolio by clicking “Add” then selecting a watchlist, or simply typing their names or tickers into the search box. Below, we add to our Comp Table a watchlist of funds, plus a metric set including Potential Capital Gain, Distribution Yield, Tax Cost Ratio, and Turnover Ratio.
To avoid relying on a single metric when evaluating tax efficiency, use Scoring Models to combine multiple metrics into a single, numerical ranking. This combination of reliable data and powerful tools is a distinct benefit of using YCharts.
According to the Tax Efficiency Score outlined below, funds that rank at or near #1 are the least tax efficient and replacing them may help defend your portfolio from looming distributions.
(The Scoring Model above ranks each metric equally at 10%; however, you can add more or less weight to any metrics you find more or less important. Scoring Models can incorporate any metric at any weight, so long as all weights add up to 100%.)
Shown below, once the Scoring Model is added to your data table, sort the results by their scores and dig into the top ranking funds, which are the least tax efficient, to decide if replacing that fund with an alternative would improve tax efficiency.
The Scoring Model found that T. Rowe Price New Horizons (PRNHX) is the most likely fund in our portfolio to have a large distribution. In the next section, we’ll show how to find similar funds that can replace PRNHX in our portfolio.
Finding more tax efficient mutual funds
To find a suitable alternative for PRNHX, click “Quickflows” at the top of its quote page, and select “Find Funds Ranked in Category” from the dropdown, which also shows other automations for many of the most common workflows used in YCharts.
This Quickflow locates Mid-Cap Growth funds, like PRNHX, that perform relatively well compared to their peers through the YCharts Fund Screener. Add another filter to this screen to exclude index funds, as their benchmark-tracking nature means they perpetually carry unrealized gains.
In the Fund Screener, add the same Tax Efficiency Scoring Model we used previously. This time around, we want to find those mutual funds with the highest scores, as they are the most tax efficient according to our model. Click the column header twice to sort by Tax Efficiency score in descending order, as shown below.
Examining a mutual fund’s distribution history
Perhaps you’re not looking to make a change in your portfolio, but you are curious about a specific fund’s distribution history for one reason or another.
To quickly and easily find that information, visit any fund’s quote page and click the “Data” tab. Next, type “dividend” in the metric field to see all historical distributions, including both dividends and capital gains.
In the example below, the Goldman Sachs Rising Dividend fund (GSRAX) distributed long-term capital gains of $9.04 per share on December 11, 2018 and brought the fund’s net asset value (NAV) down from $19.68 to about $10.64 — investors who bought GSRAX shortly before December 11th would pay $19.68 per share, immediately see NAV reduced to $10.64, then be required to pay taxes on the $9.04 per share distribution. Essentially, you would pay taxes on capital gains that the fund has accrued over time but which you, the recent investor, have benefitted from.
Viewing distributions by value and date also provides insight into potential patterns. It appears that GSRAX has issued distributions on December 11th in each of the past two years. If you’re considering investing in this fund, you could avoid the tax implications of distributions by waiting until after December 11th to invest.
Adding value with data-driven recommendations
Many advisors provide value to their clients through tax planning; creating tax efficient portfolios is certainly part of that offering.
By leveraging YCharts’ powerful tools and data, advisors can make data-driven recommendations that provide tax efficiency and protect their clients’ investments.
Data, and the ability to easily access and analyze data, are vital resources for advisors who want to position themselves and their clients for success. With YCharts, advisors can identify the right funds for the right portfolios at the right time, building trust with their clients along the way.
Want to see how YCharts can help you build better portfolios for clients and prospects? Schedule time with a product specialist or call (866) 965-7552 to speak to a team member.
©2019 YCharts, Inc. All Rights Reserved. YCharts, Inc. (“YCharts”) is not registered with the U.S. Securities and Exchange Commission (or with the securities regulatory authority or body of any state or any other jurisdiction) as an investment adviser, broker-dealer or in any other capacity, and does not purport to provide investment advice or make investment recommendations. This report has been generated through application of the analytical tools and data provided through ycharts.com and is intended solely to assist you or your investment or other adviser(s) in conducting investment research. You should not construe this report as an offer to buy or sell, as a solicitation of an offer to buy or sell, or as a recommendation to buy, sell, hold or trade, any security or other financial instrument. For further information regarding your use of this report, please go to: ycharts.com/about/disclosure