(PUB) Investing 2015

April 2015

Morningstar FundInvestor

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potential capital gains exposure. After a long streak with no capital gains payouts, the fund dished out a small 4% distribution last year. Higher-Turnover Funds The list of funds with large potential capital gains exposure has mostly very low-turnover funds, which are less likely to make big payouts. However, as you get above a turnover of 40% in a fund with a potential capital gains exposure above 40% , it’s a virtual certainty they will make a sizable distribution. They’d have to have nearly all of the turnover just in the holdings not held at a gain or all of their gains in a small number of holdings in order to avoid a payout. T. Rowe Price Health Sciences PRHSX has been making money like nobody’s business thanks to its biotech exposure. Thus, it’s probably not a surprise that it paid out about 12% of NAV in capital gains last year. With a 47% potential capital gains exposure and a turnover rate of 42% , I’d imagine those tax bills will continue. Morgan Stanley Institutional Growth MSEGX is in a similar boat. It has strong returns, a 45% potential capital gains exposure, and 42% turnover. The fund paid out a modest 5% gain last year. Fidelity Contrafund FCNTX has seen a little less in redemptions than the Fidelity funds mentioned above. It has about 10% in outflows, but manager Will Danoff also trades a bit more with turnover of 45% . The fund paid out about 7% in capital gains last year. I should note that all three Fidelity funds mentioned above are widely held in 401 (k)s and other tax- sheltered accounts, so the managers have the difficult position of trying to maximize returns equally for tax- sheltered investors and those in taxable accounts. A trade might be advantageous on a pretax basis but not on an aftertax basis if the manager only expects modest improvement by switching to a new position from a current holding that has capital gains embedded. Yet with that shareholder base, they might be inclined to make the trade anyway.

T. Rowe Price Growth Stock PRGFX has a low turn- over rate, but it has a new manager and potential capital gains exposure of 45% . The fund dished out about 10% of NAV in capital gains last year. Big Potential Capital Gains Exposure Only There are some funds that have big potential capital gains exposure but low turnover, plus stable flows and management. Even these funds will have to make payouts sometime, but I am less worried. Vanguard Primecap VPMCX is going great guns, but that means it has a 78% potential capital gains exposure. The fund distributed about 5% in gains in 2014 even though its latest turnover rate was just 11% . Touchstone Sands Capital Select Growth PTSGX has a 30% turnover ratio and a potential capital gains exposure of 47% . The fund distributed about 4% of potential capital gains exposure last year. What to Do About Capital Gains Payouts If you own a great fund, then you’d be hurting yourself if you sold it. But it might make sense to sell a medi- ocre fund that is set to make big payouts. Also, if you have automatic reinvesting for a taxable account that might make a big payout, simply turn it off. The next obvious thing to do is look closely at the situation before buying in a taxable account. If two funds are otherwise equally attractive but one lacks the big tax overhang, go with that one. Where to Find Tax-Efficient Funds Index funds are a good bet. They rarely make payouts and have low turnover. Vanguard is particularly good at managing the tax situation of its index funds. You can search for stock funds that have no or low potential capital gains exposure. Today that would mostly involve new funds or funds with really bad track records, but don’t settle for an inferior fund. œ Gabelli Asset GABAX has a potential capital gains exposure of 64% but single-digit turnover.