THE JUNE 16, 2021, edition of The Washington Post carried this headline: “Cristiano Ronaldo snubbed Coca-Cola. The company’s market value fell $4 billion.”
The incident in question had occurred a few days earlier, at a press conference in Budapest, where the soccer star was set to play in a high-profile championship game. Coca-Cola was a sponsor of the tournament, so when Ronaldo sat down at the microphone, he found two bottles of Coke positioned in front of him.
Ronaldo wasted no time in moving the bottles out of the camera’s range. To make his point clear, he put a bottle of water down instead. “Agua,” he said in Portuguese. “No Coca-Cola.”
The press conference took place just as markets were opening in the U.S. and, as the Post reported it, “The simple gesture [of moving the bottles] had a swift and dramatic impact: The soft drink giant’s market value fell $4 billion.”
Coke’s share price did indeed drop that day. But in his book Trailblazers, Heroes & Crooks, Stephen Foerster offers a more careful examination of the incident. Looking at trading data, Foerster found that Coke’s share price had already declined before the press conference, and it actually rose afterward. In other words, Ronaldo didn’t cause the share price to drop.
What did? Stock prices can rise or fall for any number of reasons. But in this case, there was something specific. June 14, 2021, was what’s known as an “ex-dividend” date for Coca-Cola. This is an important but often overlooked dynamic that affects stocks and mutual funds.
When a company is getting ready to pay a dividend, it announces in advance the date that it will be paid. That’s called the “payable date.” For logistical reasons, it sets an earlier date as a cutoff for eligibility to receive that dividend. That earlier date is the ex-dividend date, or ex-date. The idea is that shareholders who own the stock on or before the ex-date will receive the upcoming dividend, while those who purchase the stock after the ex-date won’t.
As a result, all things being equal, stocks will typically fall on the ex-date by roughly the amount of the dividend. That’s because that cash is no longer in the company’s coffers and is thus no longer a part of its value. In the case of Coke’s stock on that ex-date in 2021, the drop wasn’t precisely equal to the dividend, but it was close.
This dynamic is more pronounced and more relevant when it comes to mutual funds and exchange-traded funds (ETFs). By law, mutual funds and ETFs are required to distribute the bulk of their income to shareholders on a pro-rata basis. A fund owning stocks, for example, is required to distribute all of the dividends generated by the fund’s stocks. Similarly, a fund owning bonds is required to distribute all the interest paid by its bonds. In this way, from a tax perspective, owning a fund isn’t too different from owning the individual investments in the fund.
Fund investors, however, face another category of taxes—one that holders of individual stocks and bonds don’t have to contend with. Fund shareholders also share in the capital gains generated within the fund. If the fund’s manager decides that he wants to sell one stock to buy another, and he sells the first stock at a gain, each shareholder in the fund will have to share in the resulting tax bill. And if that trade results in a short-term gain—taxable at a much higher rate—each shareholder will bear some of that cost.
As I described a few years back, these capital-gains distributions can have a surprisingly large—and adverse—impact. Because shareholders don’t know a fund’s trading plans, this tax bill is also generally unpredictable.
All that said, I always recommend investing in the stock market via mutual funds or ETFs, rather than buying individual stocks. But how can you guard against potentially negative tax results when investing in a fund? I have five recommendations:
1. While fund distributions are unpredictable and can vary from year to year, you can at least find out the date on which they’ll be paid. That way, you can avoid making a large investment just before a distribution is paid. This scenario is a problem for taxable-account investors because it means that a portion of their latest investment is immediately returned, along with a tax bill. Taxable investors will be on the hook for that tax bill even if they opt to reinvest the distribution in additional fund shares.
Consider a new investor in American Funds’ Growth Fund of America. Last December, that fund made a distribution equal to 6.9% of the fund’s value. You wouldn’t have wanted to invest in advance of this payment because it would’ve resulted in an immediate but avoidable tax. Distribution schedules are available on fund company websites. Here are links to the 2024 schedules for Vanguard Group and Fidelity Investments.
2. Funds like the Growth Fund of America tend to make sizable distributions because they’re actively managed, which means these funds can engage in significant trading that then results in realized capital gains. Some funds are even worse. In a recent roundup, Morningstar identified dozens of funds slated to distribute 10%, 20% or more of their value this year. Index funds, on the other hand, engage in far less trading, resulting in far fewer gains. Look through the distribution history of Vanguard’s popular Total Stock Market fund, for example, and you won’t find a single capital-gains distribution in the past 10 years.
3. Within the world of index-based investments, exchange-traded index funds tend to be the most tax-efficient, owing to their structure. I described this in some detail a few years back. Long story short, the difference between traditional mutual funds and ETFs is that ETFs are baskets of stocks that are traded among investors but are almost never sold. Result: They generate very little, if anything, in the way of capital-gains distributions. The idea of a 6.9% distribution, like the one described above, would be unheard of for most ETFs.
4. If, for whatever reason, you choose to invest in an actively managed fund, check its historical distribution rate. Look back several years to see what distributions have looked like during both up and down years in the market. If a fund has a history of being tax-inefficient, and you still want to invest in it, try to make the purchase in a retirement account, where the distributions won’t be taxable in the year they’re paid.
5. Regardless of the type of fund you choose, don’t automatically reinvest distributions back into the fund, even in a retirement account. This is often a default setting, but it can cause unforeseen results. The wash sale rule, for example, can cause a negative tax result under certain scenarios.
A final note: Some funds carry very high distribution rates and advertise it as a feature. Here’s how T. Rowe Price describes its Retirement Income 2020 Fund: “Turn your investments into automatic income…. The fund’s managed payout strategy is designed to provide a stream of predictable monthly distributions throughout retirement, targeting 5% annually.”
Funds like this, however, are playing a bit of a shell game, in my view. That’s because they employ another kind of distribution known as a return of capital. As its name suggests, these distributions are simply returning a portion of a shareholder’s investment. They don’t represent income or capital gains. It’s as if you handed a fund company $100, and it turned around and handed $5 back to you. I see this as a gimmick. These return-of-capital distributions are shown on T. Rowe’s website. It isn’t the only fund company that does this sort of thing.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
The post Danger: Taxes Ahead appeared first on HumbleDollar.