BOSTON (Reuters) - Warning to mutual fund investors: the tax man is coming.
U.S. investors in stock funds will take a big tax hit this year on capital gains that could top $300 billion after portfolio managers exhausted most of their loss reserves to offset several years of stock market advances.
Even bigger tax bills may be coming the next few years too, after President Barack Obama proposed during his State of the Union speech on Tuesday raising the top capital gains and dividends tax rate to 28 percent, from 23.8 percent. The Republicans who control Congress have promised to oppose such a change.
To be sure, to get hit with a big capital gains tax bill, there must be big capital gains. But the rising toll on such profit will place a spotlight on the different methods mutual fund companies use to manage tax liability for shareholders.
"We believe it's not about what you make. It's what you keep," Boston-based Eaton Vance, which has nearly $300 billion in assets under management, said in a report called "The Return of Capital Gains," adding that many stock funds are run with too little regard for investors' tax liability.
With the stock market hitting fresh record highs several dozen times over the past two years, capital gains have been accumulating at most mutual funds. The total return on the S&P 500 Index was 13.69 percent in 2014 and 32.39 percent in 2013.
The industry's gains for 2014 are expected to exceed the nearly $239 billion distributed by mutual funds in 2013, according to mutual fund executives and analysts. The number of funds making capital gains distributions jumped to 61.4 percent in 2014, from 57.5 percent in 2013, according to Lipper Inc, a Thomson Reuters unit. Tom Roseen, head of Lipper research, said that preliminary percentage could adjust higher.
Over the next several weeks, investors will receive a tally of their capital gains distributions from U.S. mutual fund companies, whose securities are among the only ones that require their owners to pay capitals gains tax before they actually sell their shares.
Contrary to Eaton Vance, at larger cross-town rival Fidelity Investments portfolio managers are encouraged to focus on total returns and take tax efficiencies where possible, said Tim Cohen, a chief investment officer of equities at Fidelity.
"That tax efficiency question is never going to be on the top list of what we focus on," Cohen said. He added that capital gains can be minimized by investing over a long time horizon, a core tenet for Fidelity fund managers.
Funds that turn over their portfolios more frequently than peers tend to put their shareholders at a disadvantage by producing a higher percentage of short-term gains. Short term gains are taxed the same way as ordinary income, whereas long-term gains - on holdings kept in a portfolio for more than a year - are taxed at a much lower rate.
Fidelity said about 85 percent of its 2014 capital gains were long term in nature. And 80 percent of customers at the company, which manages about $2 trillion in assets and is the No. 2 mutual fund company behind Vanguard Group, are in tax deferred portfolios such as 401(k)s and other retirement accounts anyway.
Investors may not care so much about tax implications if they get the sort of returns put up by Fidelity's $12 billion OTC Portfolio. Run by portfolio manager Gavin Baker, the fund's 2014 total return of 16.49 percent beat the S&P 500 Index by 2.8 percentage points and its 2013 return of 46.5 percent beat the benchmark by a resounding 14 percentage points.
Baker's portfolio turnover tends to be higher than peers, producing a higher percentage of short-term gains. Last year, 45 percent of his fund's capital gains distributions were short term, or more than double the estimated industry-wide average.
Fidelity's Cohen said tax efficiency moves are not always compatible with producing total returns.
But sometimes they are. Oakmark Fund star manager Bill Nygren highlighted a number of strategies he uses to dampen shareholder tax liability. Since 2000, the Oakmark Fund's short-term capital gains have been about half of one percent.
The Oakmark Fund's 3-year, annualized tax-adjusted return is 21.34 percent, slightly better than the 20.58 percent produced by Fidelity OTC portfolio manager Baker. Both funds are better than 90 percent of their peers on that measure, according to Morningstar Inc.
"We want to minimize the hole in the donut lost to taxes, but do so without reducing the size of the donut," Nygren wrote in his most recent market commentary.
Reporting by Tim McLaughlin. Editing by Richard Valdmanis and John Pickering.